CAIE A2 Level

Economics

9708

Theory
Theory

The Price System and The Microeconomy

Utility
Budget Lines, Substitution Effect and Income Effect
Indifference Curves
Effiicency and Market Failure
Private Costs and Benefits, Externalities, Social Costs and Benefits
Asymmetric Information and Moral Hazard
Cost-Benefit Analysis in Decision Making
Short-Run Production Function
Long-Run Production Function
Economies and Diseconomies of Scale
Revenue and Profit
Different Market structure
Contestable Market
Imperfect Competition
Growth and Survival of Firms
Cartels
Differing Objectives and Policies of Firms
Government Microeconomic Intervention
The Macroeconomy
Government Macroeconomic Intervention
International Economic Issues

CHAPTERS

The Price System and The Microeconomy

Utility
Utility: the satisfaction gained from the consumption of a product.
Total Utility: the satisfaction from consuming all product units over a particular period.

Marginal Utility: the satisfaction gained from one more unit of a product consumed over a particular period
of time. Tends to fall as consumption increases.
Note: Consumers purchase products when P≤MU P ≤ MU
The Law of Diminishing Marginal Utility: the fall in marginal utility as consumption rises.
Assuming limited income, rational behaviour and a goal to maximise total utility.
Equi-Marginal Principle: Consumers maximise their utility where their marginal valuation for each product
consumed is the same.
It can be used to draw up a demand curve. Price rises for product A; marginal utility will be less than
other goods and reduce the buying of consumers of A compared to other products due to their goal of
maximising total utility. Through it, we get to know the level of demand for consumers.
𝑀𝑈 ∗ 𝐴 = 𝑀𝑈 ∗ 𝐵 = 𝑀𝑈 ∗ 𝐶 = ⋯
𝑃∗𝐴 𝑃∗𝐵 𝑃∗𝐶
P ∗ AMU ∗ A = P ∗ BMU ∗ B​= P ∗ CMU ∗ C​= ⋯

Limitations of Marginal Utility and Rational Consumer Behaviour

Customers can not always put wants in order of most satisfaction, as some products may carry the same level
of satisfaction or may change depending on mood.
Customers may not always be able to assign a value to their satisfaction, as it is difficult to put intangible
thoughts and feelings to numbers.
It also assumes rational behaviour from consumers, that they will be satisfied with more rather than less.

Budget Line, Substitution Effect and Income Effect

Budget Line: The combination of two products obtainable with given income and prices.

Substitution Effect: Following a price change, a consumer will substitute the more expensive product for the
one that is now relatively cheaper.

Income Effect: The resultant change in demand for a good or service caused by an increase or decrease in a
consumer's purchasing power or real income.

The income effect has a positive relationship with normal goods, meaning if income increases,
consumers can **purchase more of the normal goods.
The income effect has an inverse relationship with inferior goods, meaning if income increases,
consumers will purchase less of the inferior goods.
These cause a shift in the budget line:
A rightward shift for normal goods.
A leftward shift for inferior goods.

Indifference Curve
Indifference Curve: This shows the different combinations of two goods that give consumers equal
satisfaction. It represents the extent to which consumers are willing to substitute one good for another.
Marginal Rate of Substitution: The rate at which a consumer is willing to substitute a good for another. This
affects the slope of the curve.

Consumers are indifferent to x, y, and z since they are all on the same curve. The equimarginal principle is
applied here.
A higher indifference curve (I2) indicates a higher level of consumption and utility. The higher the curve
placement, the more preferable.

The budget line represents the extent of consumer income, and the indifference curve indicates the extent of
available consumer choices. Together, they show how consumers can maximize satisfaction.
A consumer’s choice is optimal at the point where the budget line is tangent to the highest indifference curve.
This point shows the marginal rate of substitution.

Following a price decrease for Normal Good B, a price decrease for Good B increases the consumer's
purchasing power (they can now buy more).

A shift from consumer equilibrium, E1 to E2, is the substitution effect. Consumers will now
purchase more of Good B as it is relatively cheaper than Good A.
A shift from consumer equilibrium, E2 to E3, is the income effect. With more purchasing power, the
budget line shifts to B2, allowing more of Good B to be purchased while keeping Good A constant.

Summary of Effects:

Substitution effect: E1 to E2, a shift in the budget line causing movement along the indifference curve.
Income effect: E2 to E3, a shift to a new indifference curve.
Price Effect = Substitution Effect + Income Effect.

Example: An increase in the price of Normal Good B.

Substitution effect: E1 to E2. Consumers switch to buying more of Good A.

Income effect: E2 to E3. Reduced purchasing power negatively affects consumption of both goods.

For inferior goods, an increase in purchasing power results in less consumption of Good B (consumers favor
more expensive goods). This creates a negative income effect, which may not fully offset the substitution
effect.

Giffen Goods are a sub-category of inferior goods, where consumption increases as price increases. This is
due to a strong income effect:
When the price of a Giffen good increases (e.g., staple food like rice), the substitution effect is negative
(budget decreases), but the strong positive income effect dominates.

Price Effects Table

Price Change Good Type Price Effect (on demand) Demand Change
Fall Normal Both effects ↑ Rise
Fall Inferior Substitution ↑ > Income ↓ Rise
Fall Giffen Substitution ↑ < Income ↓ Fall
Rise Normal Both effects ↓ Fall
Rise Inferior Substitution ↓ > Income ↑ Fall
Rise Giffen Substitution ↓ < Income ↑ Rise

Limitations of Indifference Curve Analysis

Consumers are not always rational; emotions and personal judgment influence decisions.
Consumers may not fully realize the level of utility from consumption.
Indifference curve analysis is limited to two (or at most three) goods, not accounting for all goods in a basket.
The model is unsuitable for durable goods (e.g., comparing cake to a cake pan).

Efficiency and Market Failure

Economic Efficiency: where scarce resources are used most efficiently to produce maximum output. Consists of:

Productive Efficiency: When a firm is producing at the lowest possible cost.

Allocative Efficiency: where price equals marginal cost; firms produce the goods and services most
consumers want. No waste, both producers and consumers are satisfied with produced goods.
The marginal cost of production measures the opportunity cost of resources used to produce this unit.

Productive Efficiency

Productive Efficiency only exists when producing in the border of a PPC curve.
Competition may lead to productive efficiency, forcing firms to lower prices and not go bankrupt, and will
lead to firms reducing their costs to get the greatest possible profit.
Perfect Competition pushes firms to long-run equilibrium in the market by producing at q and price at p.
Lowest Average cost is achieved, leading to productive efficiency in the economy.

Productive_efficiency.svg

Allocative Efficiency

The table below, shows us the most allocative efficient output would be Quantity 4.

Quantity 12345
Price per unit 66666
Marginal cost per unit 3 4 5 6 7

It cannot be expressed using a PPC curve. Any point on the frontier/border as long as the marginal cost and
selling price are the same.
A competitive market can lead to allocative efficiency. It leads to 2 motivations: motivation to make the
greatest profit so they will produce the products with the highest level of demand; second, the other firms will
be producing high-demand products, which forces other firms to do the same to prevent failure and closure of
the firm.
Allocative efficiency can be seen in the graph, where the marginal cost curve meets the price.

Pareto Optimality

Pareto Optimality: where it is impossible to make someone better off without making someone else worse
off.
If resource allocation is not Pareto efficient, then there is scope for improvement.
Any improvement in economic efficiency will need some form of compensation to individuals negatively
affected by the improvement.

Dynamic Efficiency
Dynamic Efficiency: a productive efficiency that benefits a firm over time. Resources are reallocated so that
output increases relative to the increase in resources.
The long-term phenomenon is achieved when firms meet the market's changing needs by introducing new
production processes in response to competitive pressures and require investment with outside firms. When a
firm becomes dynamically efficient, the long-run average cost curve shifts downwards.

Market Failure

Market Failure is when a free market fails to make the optimum use of scarce resources due to no government
intervention. It is when a market's interaction between supply and demand does not lead to productive and/or
allocative efficiency.
Reasons for market failure (oversupply or undersupply of goods):
Externalities present in the market
No Provision of merit and demerit goods
No Provision of public and quasi-public goods
Information failure exists
Adverse selection or moral hazard
Abuse of monopoly power in the market

Private Costs and Benefits, Externalities, Social Costs and Benefits

Social Costs
Social Costs = Private Costs + External Costs

Social Costs: the total costs of a particular action borne by all the society.

Private Costs: those costs that are incurred by an individual who produces a good or service.

External Costs: those costs incurred and paid for by third parties not involved in the action.

Marginal Social Costs

Marginal Social Costs = Private Marginal Costs + External Marginal Costs

Marginal Social Costs: the total cost society pays for the production of another unit or for taking further
action in the economy.
Private Marginal Costs: the change in the producer's total cost due to producing an additional unit of a good
or service.
External Marginal Costs: the change in the cost to parties other than the producer or buyer of a good or
service due to the production of an additional unit of the good or service.

Social Benefits
Social Benefits = Private Benefits + External Benefits

Social Benefits: the total benefits arising from a particular action.

Private Benefits: benefits that accrue to individuals who produce and consume a particular good.
External Benefits: benefits received by third parties not involved in the action.
If social benefits rise more than private, positive externalities are present.

Marginal Social Benefits

Marginal Social Benefits = Marginal Private Benefits + Marginal External Benefits

Marginal Social Benefits: the satisfaction experienced by consumers/producers of a specific good, plus the
overall environmental and social benefits.
Marginal Private Benefits: the total marginal benefits of every consumer for each quantity of good
consumed.
Marginal External Benefits: the benefit from consuming one more unit of a good or service that falls on
people other than the consumer.
the 4 kinds of externalities (Positive consumption externalities, negative consumption externalities,
Positive production externalities and negative production externalities)

Externalities

Externalities: where the actions of producers or consumers give rise to side effects on third parties who are
not involved in the action; sometimes referred to as spillover effects.
Negative Externalities: where side effects negatively impact and impose costs on third parties.
Negative Production
Negative Consumption
Positive Externalities: where the side effects positively impact and benefit third parties.
Positive Production
Positive Consumption
Arise through the actions of consumers and producers, distinction is sometimes not always clear.
Externalities create the problem of an inappropriate amount of goods and services being produced. Firms do
not usually take into account all social costs, only private. Thus, the overproduction of goods with negative
externalities will continue due to no acknowledgement of social costs by private decision-makers.

Negative externality in production

The graph above shows how Marginal private costs (MPC) is the level of supply currently produced, with
price P and quantity Q; since negative externalities of production are not acknowledged, firms overvalue
(as it may seem like a higher profit margin) and hence overproduce, and the market is in a disequilibrium.

Only through government intervention and the acknowledgement of the negative externalities will the supply
shift to the left, causing P to shift to P* and Q to shift to Q*, and will the market be in equilibrium.

Deadweight Welfare Loss: A deadweight loss is a cost to society created by market inefficiency, which
occurs when supply and demand are out of equilibrium.

Market inefficiency occurs when goods within the market are either overvalued or undervalued.

Deadweight welfare loss is indicated by the triangle in the graph.

Positive externalities may also cause deadweight loss. In the graph above, Marginal Private Benefit (MPB) is
the level of current demand, with price P and quantity Q; since Positive externalities of consumption are
not acknowledged, consumers undervalue (since they are not aware of the actual benefit), and hence
producers underproduce, and the market is in disequilibrium.

Only through government intervention and acknowledging the positive externalities will the demand shift to
the right, causing P to shift to P* and Q to shift to Q*, and the market will be in equilibrium.

Asymmetric Information and Moral Hazard

Asymmetric Information

Asymmetric Information: occurs when one party to an economic transaction possesses greater material
knowledge than another.
Where people do not have full or complete information and do not realise the benefit of a merit good or the
side effects of a demerit good.
Moral Hazard: the tendency for insured or otherwise protected people to take a greater risk. This situation
arises from Asymmetric Information, where the person in the market is more informed than the seeker of
advice/buyer.
For example, a doctor's diagnosis.
This could lead to a misallocation of resources
More of a risk as it is not done purposefully by the person in the market.
Adverse Selection: where an insurance company encounters the probability of extreme loss due to a risk not
divulged at the time of a policy's sale.
For example, when applying for health insurance, the insured hides bad habits (smoking, drinking,
etc.).
This case of information failure is due to information being withheld or portrayed inaccurately. This is
more purposeful.

Negative Consequences of Asymmetric

Positive Consequences of Asymmetric Information
Information
Specialisation is encouraged in a healthy economy. The People can be taken advantage of, and encouraging
economy will benefit from trade and the Division of labour. immoral activity may reduce living standards.
Adverse selection can take place, which results in
Greater aggregate demand and a better standard of living.
negative externalities.

Cost-Benefit Analysis in Decision-Making

Cost-Benefit Analysis (CBA): a method for assessing the desirability of a project, taking into account the
costs and benefits involved.
Used to measure the feasibility of a project/business. Weighing the costs with the benefits and comparing
them to the opportunity cost Aims for a competitive advantage.
The technique assumes that a monetary value can be placed on all the costs and benefits of a program,
including tangible and intangible returns to other people and organizations in addition to those immediately
impacted.

Stages in a Costs-Benefits Analysis

1. Identification of all relevant costs and benefits.

2. Putting a monetary value on all relevant costs and benefits.
3. Forecasting future costs and benefits (where appropriate).
4. Decision-making - the interpretation of the results from CBA.

Step Advantages Disadvantages

Identification All costs/benefits considered Identification is tough
Monetary evaluation Most will have market prices Shadow prices
Forecast Future consequences Uncertainty in estimation
Interpretation All info. Useful Bureaucracy
Decision-making Investment projects Public expenditure

Short-Run Production Function

Short-run production function defines the relationship between 1 variable factor of production (while keeping
the rest fixed) and output.
Short-run is not a period of time, but rather a condition where not all factors of production are variable.
The production function shows the maximum possible output from the given set of factor inputs.
Formula: Q=AF(K, L), where Q is total output (Quantity), A is technology, and F is factors of
production, with K being capital and L being labour.
Total product is the total output a firm produces within a given period, utilising given inputs.
Total product = Average product x labour
Average product, output per unit of inputs of variable factors.
Average product = Total product
Labour Average product = LabourTotal product​
Marginal product is the addition of variable factors to the total product.
Marginal product = Changed output
Changed input Marginal product = Changed inputChanged output​
The Law of Diminishing Returns (law of variable proportions) is where the output from an additional
input unit leads to a fall in the marginal product.

Short Run Cost Function

Fixed Costs: Those costs are independent of output in the short run, so they are a straight line and don’t
change with output.
Variable Costs: those that vary directly with output; all costs are variable in the long run, so the graph is
curved and changes with output
Total cost = total fixed cost + total variable cost. It starts at the fixed cost line and follows the variable cost
line, since it combines both.

Average Fixed Cost = total fixed cost Average Fixed Cost = outputtotal fixed cost​
output
Average variable cost = total variable cost Average variable cost = outputtotal variable cost​
output
Average total cost = total cost
output Average total cost = outputtotal cost​
change in cost
Marginal cost = change in quantity Marginal cost = change in quantitychange in cost​

Isoquant: a curve that shows a particular output level over a combination of inputs. It is similar to the
indifference curve. Output refers to the total physical product.

An example graph given below. The points x, y and z on the graph show the same output.

Optimum Output: most efficient output at the lowest unit cost. Production efficiency in the short run.
Optimum output ≠ profit maximisation (this is a long run).

The short-run average cost curve (SRAC) shows us the optimum output point where marginal cost meets the
lowest point of average total cost.
The cup shape of the curve is because, initially, the average cost reduces due to increased efficiency and
better-fixed factors, known as increasing returns. It continues to drop until the Optimum output is
reached. Then, as the additional cost of producing more units becomes a burden (increase in marginal cost),
diminishing returns happen, leading to increased average total cost and the slope turning upward.

Long-Run Production Function

In the long run, all factors of production are variable. This allows factor input to be manipulated to find the
most efficient level.
Increasing returns to scale: where output increases proportionately faster than the increase in factor inputs.
Decreasing returns to scale: where factor inputs increase at a proportionately faster rate than the increase in
output.

Long Run Cost Function

Long-run cost

The reason the curve is sloping is because, over-time, economies of scale reduce costs and output increases
(increasing returns to scale), but there will come a point where costs reach the lowest they can while output is
highest, and once firms surpass that point, diseconomies start to gain.
Minimum Efficient Scale: lowest level of output at which costs are minimised.
Low MES leads to a fragmented market, and high MES levels lead to a natural monopoly.

Long-run average cost cure-envelope curve

LRAC is also known as the envelope curve, consisting of the short-run average costs over time.

Economies and Diseconomies of Scale

Economies of Scale - the benefits gained from falling long-run average costs as the scale of output increases.

Internal Economies of Scale: a long run result of a decision to produce on a larger scale.

The principal advantage for a firm benefiting from economies of scale is a reduced cost per unit produced.

Technical Economies Advantages gained directly in the production process

Purchasing economies Increase purchase power, bulk buying, cheaper inputs
Marketing economies Promote at lower rates, saving in costs of distribution
Managerial economies Specialisations and specialists/experts
Technological economies Cost saving through online advertising and booking systems
Financial economies Better and cheaper access to borrowed funds
Risk-bearing economies More risk-averse due to diversified conglomerate activity

External economies of scale: cost-saving accruals to all firms in an industry as the scale increases.

Economies of Concentration: Increase in the power of the wealth and thus the influence of government
interventions, such as taxes and tariffs.
Economies of Technology: Involvement of better and advanced technologies and sciences in relation to
economic activities.
Economies of Skills: Where skilled/specialised people can work more efficiently and cost-effectively.

The Benefits:

Egalitarian: All the businesses in an industry enjoy these economies of scale equally.
Growth: stimulate industry growth in particular regions and encourage the rapid economic development of
support industries and the wider geographic area.
Lower Costs: Besides lower production and operating costs, economies of scale may reduce variable costs
per unit because of operational efficiencies and synergies.

Diseconomies of Scale: where long-run average cost increases as the scale of output increases

Internal Diseconomies of scale are possible because the excessive concentration of economic activity in a
narrow geographical area will lead to disadvantages.
Technical Diseconomies: inefficiencies in the production process. When companies grow faster than
they can adapt and can't meet demand, they meet scalability issues.
Organisational Diseconomies: inefficiencies in the workforce management. Additional growth
requires additional workers to the workforce. This can cause issues with communication and
motivation, thus reducing employee productivity.
Purchasing Diseconomies: laxity in purchasing due to additional cash inflows, which creates problems
of irresponsible spending, greater waste, higher costs and even lack of progress.
Competitive Diseconomies: This happens due to non-competitive markets; this lack of tangible
incentives causes inefficiency.
Financial Diseconomies
External diseconomies of scale come in the form of:
Traffic Congestion, which increases distribution costs.
Land Shortages and, therefore, rising fixed costs.
Shortage of Skilled Labour and, therefore, rising variable costs.

Revenue and Profit

Revenue

Total Revenue (TR) = price x quantity

Average Revenue (AR) = totalOutput
revenue Average Revenue (AR) = Outputtotal revenue​

Marginal Revenue (MR) = change in total revenue

change in total output
Marginal Revenue (MR) = change in total outputchange in total revenue​
Marginal revenue is the additional revenue gained by the additional unit.
The firm only sells more by reducing price; AR is always higher than MR. The demand curve is the AR line.

Profit

There are 3 types of profit:

Normal Profit: a cost of production that is just sufficient for the firm to keep running in the same industry
Subnormal Profit: any profit less than the normal profit. If the problem persists, then the firm will leave the
industry and go into one that will make a profit.
P<AC, price less than average cost.
Supernormal Profit: any profit in excess of normal profit. It only exists in the short term and only for
monopolies,
TR>TC, the total revenue is greater than the total costs.

Different Market Structure

Industry: a group of productive enterprises or organisations that produce or supply goods, services, or
sources of income.
MNC: A multinational corporation (MNC) has business operations in two or more countries.
Market Structure: the way in which a market is organised in terms of the number of firms and barriers to the
entry of new firms.
Barriers to Entry: any restriction that prevents new firms from entering an industry.
Spectrum Structure:
Large ← ← Number of firms → → Small
None ← ← Barrier to entry → → High
None ← ← Control over price change → → Full
Perfect Competition: an ideal market structure with many buyers and sellers, identical or homogeneous
products and no barriers to entry. It is on the furthest left end of the spectrum.
Imperfect Competition: any market structure except for perfect competition.
Monopolistic Competition: a market structure where there are many firms, differentiated products and few
barriers to entry. This falls after perfect competition in the middle of the spectrum structure.
Oligopoly: is a market structure with few firms and high barriers to entry. Falls after monopolistic
competition in the middle of spectrum structure.
Monopoly: a pure monopoly is Just 1 firm in an industry with very high barriers to entry. It falls at the
furthest right end of the spectrum

Stages to help identify the market structure in the spectrum:

Count firms, larger numbers, closer to perfect competition.

Concentration ratio to see the combined market structure of the biggest firms as a percentage of the industry
total. The bigger percentage is closer to oligopoly and monopoly.
Considering barriers to entry
Considering the importance of economies of scale to a firm, the more it is, the closer to oligopoly.

Barriers to Entry:

Access to Capital: The market could have high fixed costs/set-up costs, such as research and development,
which might require a high salary over a long period to be profitable.
Sunk costs act as a barrier to exit, and the high risk of entry and failure prevent potential firms from
entering.
Advertising and brand names with high consumer loyalty are hard to achieve, so they deter firms as they
are also regarded as a form of investment.
Start-ups have less advantage of economies of scale, and large firms can take advantage of their economies
of scale and use predatory pricing.
Patents restrict the use of production processes/products.
Some existing firms may have monopoly access to raw materials, components and retail outlets.

Concentration Ratio

Concentration Ratio: the collective market share of the largest firms in the industry.
It is found by taking the ‘n’ number of top firms and adding up their market share. Then, put them in a
ratio.
Company A's market share is 10%, company B's market share is 15%, company C's market share is 20%, and
company D's market share is 25%.
the ratio would be n=4, total market share of the top firms=70, thus 4:70.
Important note: Only add the big dominators, not all the firms in the market.
The higher this concentration ratio, the more concentrated the market is (more competition).

Perfect Competition
Theoretical Extreme, the only applicable example is the produce market, which has the following
characteristics:
Perfect knowledge about market conditions and prices by all buyers and sellers.
Individual firms have no influence on market price, which is determined by market demand and
quantity-supplied forces. Firms are price takers.
All products are identical (same quality and identical to every consumer)
Freedom of entry into and exit from the market.
Demand = Average revenue = Marginal revenue.
This is because firms cannot influence price; they just take it. This leaves the marginal revenue
constant, which makes equal average revenue (Additional units will give the same revenue every time).
The price is equal to AR and MR.
The chosen output will be where MC = MR (price), the profit maximisation point.
Abnormal profit results in the short run, but since it creates incentives for new firms to enter, supply rises,
causing prices to fall and profits to return to normal.
Long-run equilibrium leaves only productive and allocative efficient firms due to normal profit.
The Shutdown price is when P=AR=AVC.
If the firm’s price (average revenue) falls below its average variable cost, it is making an operating loss
since that would mean the total revenue would be less than the variable costs. This is short-term
since firms may return from this loss by cutting costs, loans, economic growth, etc.
The long-term shutdown price is when the price is less than the minimum ATC; the firm will have
to exit the market permanently since it cannot cover all its costs.

Contestable Market
Contestable Market: Any market structure with a threat that potential entrants are free and able to enter this
market.
No cost for entry, and it exists in the perfect contestable market. The government does this to deregulate the
market and make it more competitive.
Features of Contestable Market
Free entry
The number and size of firms are irrelevant.
Only normal profit can be earned in the long run.
The threat of potential entrants into the market is overriding
All firms are subject to the same regulations and government control.
Mechanisms must be in place to prevent unfair pricing designed by established firms to stop new firms
from entering.
Cross subsidisation is eliminated.

Imperfect Competition
any market structure except for perfect competition

Monopolistic Competition
Characteristic:
Numerous buyers and sellers
Few barriers to entry
Wide choice of differentiated products
Firms have some influence on market price
Similar to perfect competition, except for product differentiation. This requires brand image, so advertising
and promotion play a big role in this market structure.
Firms can charge prices above marginal cost, which means as the firm makes more of the product, the price
is lowered, and that’s why marginal revenue is below the demand curve.
In the short-run, as firms aim to maximise/minimise profit, they will aim to produce where MC=MR; this has
them making an abnormal profit. Like perfect competition, this creates incentives for new firms to enter
due to low barriers to entry. But unlike perfect competition, firms can set their prices; this creates
competition and shifts prices from where it meets demand to where it meets ATC and MC. This leads to
losses, but as firms are free to exist, these losses are turned into normal profits.
In the long run, firms will still produce where MC=MR; however, the demand curve would have shifted to
the left due to competition and firms entering the market. This causes normal profit and excess capacity,
as firms won’t produce at minimum ATC in the long run.

Oligopoly

Characteristics:
Dominated market by a few firms
Decisions are interdependent on rival strategies/reactions.
High or substantial barriers to entry
Products may be differentiated or not.
The uncertainty and risk associated with price competition may lead to price rigidity.
Oligopoly behaviour can follow 2 routes, aggressive competition in the form of price wars and another less
risky approach through non-price competition to increase revenue and horizontal integration.
Non-Price Competition
physical characteristics
location
service level
advertising
The second route is cooperation and collusion.
Cooperation like research and development, where firms pool their knowledge and perhaps participate
in joint ventures.
Collusion is different; it is anticompetitive action by producers;
Price Leadership: a situation in a market whereby a particular firm has the power to change prices, the result
of which is that competitors follow the lead.
Cartel: a formal agreement between firms to limit competition by limiting output or fixing prices.

Main Theories to Attempt to Explain Oligopolistic Behaviour

The Kinked Demand Curve

is a means of analysing firms' behaviour in an oligopoly without collusion.

The kinked demand curve shows how oligopoly firms won’t be able to have price competition, and that will
lead to the temptation to collude.

Impact of Price Rise

In the graph above, p is the equilibrium price; if the price rises above that, there will be a Reverse movement
along the demand curve, causing a reduction in Q (quantity) and a reduction in MR (marginal revenue).
If a firm increases the price, it becomes more expensive than its rivals, so consumers will switch to its
rivals.
Therefore, for a price rise, there is likely to be a significant fall in demand. Demand is, therefore, price
elastic.
In this case, by increasing price, firms will lose revenue because the percentage fall in demand is greater than
the percentage rise in price.

Impact of Price Cut

In the graph above, p is the equilibrium price; if the price reduces below that, there will be Forward
movement along the demand curve, causing a slight increase in Q (quantity), a reduction in MR
(marginal revenue) and a significant increase in MC (marginal cost).
If a firm cut its price, it will likely lead to a different effect. In the short term, if a firm cuts price, it would
cause a big increase in demand, leading to a rise in revenue. The firm would gain market share.
However, other firms will not want to see this rise in market share, so they will respond by also cutting
prices to follow the first firm. The net effect is that if all firms cut-price – the individual firm will only see a
small increase in demand.
Because there is a ‘price war’, demand for a firm is price inelastic – there is a smaller percentage rise in
demand.
If demand is inelastic and price falls, then revenue will fall.

Game Theory

Showcases interdependences that a kinked demand curve cannot showcase.

This diagram showcases the different options a firm can decide based on competition and price.
Prisoners’ dilemma is showcased here, with a Nash equilibrium and dominant strategy.
The Nash Equilibrium: a decision-making theorem within game theory that states a player can achieve the
desired outcome by not deviating from their initial strategy. In this case, the Nash equilibrium is either selling
for 1 dollar for companies A and B, where each gets 3 million in return.
Dominant Strategy: the optimal option for a player among all the competitive strategy sets, no matter how
that player's opponents may play. Company A would prefer to sell at 0.9 dollars to gain 4 million in the above
example.
Prisoners’ Dilemma: when both parties are under the guise of guilty, where if both fess up, punishment is
shared if one is proven guilty, full punishment, This causes both parties to be in a dilemma. Related to pricing
strategy.
Principal Agent Problem: a principal hires an agent to own the business, but there is a case of info. Failure,
since the principal, cannot ensure that the appointed agent makes the necessary decisions to run the firm in the
best interests of shareholders. For ex. the agent is following the objective of satisfying, whereas the principal
believes he or she is implementing a policy of profit maximisation.
Price rigidity (non-price competition) like the Nash equilibrium is not the best outcome, therefore pushes
firms to collude and use tactic collusion.
It also provides an incentive to cheat on collusive agreements, which could put firms at risk of being caught,
which could reflect negatively.

Monopoly

A pure monopoly is a single firm, but in real life, a monopoly can be a firm with a large percentage of market
share and a mass dominant position.
In theory characteristic:
Single seller
No close substitutes
High barriers to entry
The monopolist is the price maker
Local monopolies can exist because it could be too costly for the others to set up, even tho it could be a small
firm.
No distinction between short-run and long-run due to barriers of entry and no economic incentive for the
monopolist to move away.
Monopoly sets prices higher than market equilibrium (where MC=ATC), causing them to make supernormal
(abnormal) profits. This would normally attract new firms, but due to the higher barriers of entry, no effect on
the profit occurs.
Natural Monopoly:
Where a single supplier has a substantial cost advantage such that competing producers would raise
costs and where duplication will produce an inefficient use of resources. This can also be done by the
government, for example, utilities, because private firms may exploit the customers.
It could be making an abnormal profit, but if it behaved like a competitor firm, equilibrium is where
price = long-run marginal cost. This leads to price and added quantity loss, causing a loss without
government subsidies. That is why being in the public sector is more logical.
Positives of Monopoly
a monopolist cannot always make abnormal profit
the competitive market has an uncertainty of profits - monopolists can invest in this and provide better
quality products and job security.
Investment may take the form of process innovation.
Profit would be used to finance product innovation.
If the benefits of economies of scale were passed on to consumers, they would have gained from it.

Comparing Monopoly and Perfect Competition

Monopoly price higher than perfect

Monopoly output lower
Monopolists making long and short-run abnormal profits
Productive efficiency and producing optimum output in perfect competition and also allocative efficiency,
price = MC.
Monopolists take consumer surplus and make abnormal profits.
X inefficiency - where the typical costs exceed those experienced in a more competitive market. This happens
when the firm lacks the incentives to lower the costs.
The monopoly firm is productively inefficient, producing less than the optimum output in the search for extra
profit. The price change is well above marginal cost and is not allocative efficiency.
If a perfectly competitive industry were turned into a monopoly, there would be a welfare loss of area x and
greater allocative inefficiency.

Growth and Survival of Firms

Existence of Small firms (and reasons why firms decide to remain small):

Support large firms through economic activity in small markets.

Spread of skills
Personal attention in service to customers
Can be future big firms in making
Obstacles of growth lead to it staying small.
Expansion is not an objective
The recession and rising unemployment trigger an increase in start-ups.
Financial help from the government
More efficient and competitive (Quick response to changes in the market).

Growth
Internal Growth: the firm decided to retain profit and invest it in the business to grow and expand.

Reduction in average total cost of overtime due to economies of scope.

Economies of Scope: reduction in ATC made possible by a firm increasing the goods it produces.
Achieve higher profits → Boost sales → Profit.
Diversity in product range due to economies of scale.

External Growth: The firm expands by joining together through takeovers or mergers.

Diversification: where the firm grows by producing or selling a wide range of products.
Vertical Integration: where the firm grows by merging or taking over with other firms, producing backwards
or forward in the supply chain.
Vertical forward integration (forward supply chain)
Vertical backward integration (backward supply chain).
Conglomerate Integration: producing in an unrelated industry.
Horizontal Integration: where a firm merges or takes over another in the same industry.

Reasons for Integration

Capture resources from other businesses.

Benefit from their experience and knowledge of the market, especially if the firm wants to integrate into a
new industry (Vertical integration or conglomerate).
Diversity in production lines reduces the risk for firms.
To avoid being taken over by other larger firms, the firm will merge or take over other smaller firms in the
industry (horizontal).

Consequences of Integration

Economies of scale and scope (positive outcome)

Diseconomies of scale (Negative outcome)
Conflict in decision-making arising from different management cultures.
The owner may lose control due to the addition of the stakeholders. This may lead to conflict in objectives
between the owner and the rest of the stakeholders.

Cartels
Cartel: a formal agreement between firms to limit competition by limiting output or fixing prices.
Types of cartel agreement:
Price Fixing: maintain or fix a minimum pricing strategy where they cannot sell below the floor
price. They may also require the unison raising of prices and avoid discount pricing.
Market Share: divide the market (customers and regions) between the members to ensure even
revenue distribution. This is done by restricting the other members’ involvement in that region.
Terms of delivery, agreeing on modes, location, billing, etc.
Output and production agree on the production level to influence/force higher price trends for goods
or services.

Positive consequences Negative consequences

Monopoly power advantages to its members Act as a barrier to entry by discouraging new entrants.
Save costs to members through economies of scale Lack of competition creates inefficiency in the market.
Prices for goods and services at higher margins to Harm consumers, as prices are greater than the market price,
maximise profit. and supply is restricted.

Differing Objectives and Policies of Firms

Profit Maximisation
Firms want to increase the level of profit they receive from given output. Thus, why is profit
maximisation an objective?

Profit_max_marginal_small.svg

In the graph above, when the marginal revenue is greater than the marginal cost, the firm gains increasing
profit levels, at which MC=MR is the maximum profit level for the given output. However, if the marginal
cost exceeds marginal revenue, the firm will be making a loss for each unit produced.
Short-term profit maximisation may not be of interest long term:
Avoidance of government watch
Large abnormalities may attract new entrants
High profits may decrease relationships with stakeholders.
Management may have different objectives.
Survival
The very common objective, the first objective of a new startup, and the prioritized objective to a
declining in-loss firm.
It's not a profit-centred objective.
Survival objectives ensure the firm is operating, regardless of profit. This objective focuses on ensuring
the business doesn’t fall into a loss and has enough to cover its Total costs.
Profit Satisfying
A firm aims to make a reasonable profit level to satisfy all shareholders.
Sales Maximisation: a firm’s objective to maximise the volume of sales.
Cross subsidisation (the strategy of funding one product with the profits of another) is used since
higher output relative to revenue causes loss, and firms need ways to cover ATC.
This objective may draw new entrants but can be deterred by price wars.
Revenue Maximisation
A firm’s objective to maximise turnover, MR=0.
Accept low prices and above profit maximisation output to increase market share, called penetration
pricing policy.
It can be favoured if management salaries are linked to the value of sales.

Pricing Policies

Price Discrimination

Price Discrimination: 3 recognised types of price discrimination:

First Degree: The firm sells at different prices for different consumers based on their ability
/willingness to pay. The main focus is on maximising willingness to pay
Demand curve = MC
Price = MR
Second Degree: Consumers will only buy more of a product when the additional units are lower in
price, which causes firms to charge a higher price for the first unit and lower for the successive.
Total revenue and profit rise.
Third Degree: Discriminate between consumers based on the presumption that groups of consumers
have a different price elasticity demand for the product.
The aim of price discrimination, if taking advantage of consumer surplus, is to maximise producer
surplus.
Conditions for Price Discrimination:
The degree of monopoly power needs to be a price maker.
Be able to identify the different market segments.
The elasticity of demand for different consumers is known.
Firms need to prevent re-sale of products by consumers. This could result in the exploitation of
consumers.

Consequences for Consumers Consequences for Producers

Increased revenue through increased
Lower prices for some consumers profit-making opportunities. Helps
businesses to make up losses
Regulated demand can help reduce the
Reduce consumer surplus crowd in peak season and increase during
the off-season.
With lower product choices, monopolies can take advantage to achieve Administration costs, for example, the
greater market share and establish a high barrier to entry. This reduces costs spent to prevent the reselling of
welfare, and lower-income consumers may be unable to afford it. goods.
Creates unfairness in society

Limit Pricing: seeks to keep firms out of the market. Short-term method used by oligopolists and
monopolists.
Predatory Pricing: Prices are set very low, sometimes below average total cost, to drive out competition and
create a monopoly.
Price Leadership: Commonly used by oligopolies, the highest market share business sets lower short-term
prices, and the rest follow. This can cause a small business to be driven out.

Note: relationship between price elasticity of demand, marginal revenue and total revenue.

MR and PED have a direct relationship: Positive MR= Elastic demand, Negative MR=Inelastic demand.
MR is a part of the total revenue. MR is used to find the optimum output level that maximises sales and
profit; positive MR= TR increases, and negative MR= TR decreases.

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