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A Level Economics Aqa Unit 3 Notes

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Economics Unit 3 Notes ­ Poverty and the Distribution of Income and Wealth Short­Hand Glossary:

• EG = Example, often to give a real world example of a theoretical point

• GVT = Government

• SR/ST = Short­run / Short­term

• LR/LT = Long­run / Long­term

• MC = Marginal cost

• AVG = Average

• AC = Average cost

• MR = Marginal revenue

• AR = Average revenue

• Max. = Maximisation

• Profit.max = Profit maximisation

• + = And

• / = Or

• UE = Unemployment

• D = Demand

• S = Supply

• EOS = Economies of scale

• PC = perfect competition / perfectly competitive
Production and cost theory:

• Production is a process of converting inputs into outputs

• Short run ­ At least one of the inputs/factors of production is fixed/in fixed supply

• Long run ­ All factors of production can be changed, none are fixed

• Time length of SR/LR varies from industry to industry. EG For an ice cream business, the LR might be a few days to buy an extra van, BUT nuclear plant much longer, as a
new factory will take decades to build. The SR is very long for a nuclear power plant
therefore, as for decades at least one factor will be fixed.

• Law of diminishing marginal returns is a SHORT­RUN phenomenon

• Law of diminishing returns ­ A SR law which states that, as a variable factor of
production is added to fixed factors, eventually the marginal returns of the variable
factor begin to fall, then AVG returns fall, then total returns fall. This happens, for
example, because the gains from further specialisation diminish, or capital equipment
becomes diluted among a larger workforce.

• BUT, in LR, all factors are variable + the scale of the operation itself can be changed,
so the law of diminishing returns does not apply.

• In the LR, returns to scale are what matter, i.e., how increasing scale affects output

• Returns are related to cost and maximum productive efficiency is achieved at lowest
AVG cost, or highest AVG physical product.

• Increasing returns to scale ­ When an increase in all of the factors of production
cause a more than proportionate increase in output (i.e. % change in output > %
change in inputs)

• Fixed costs ­ the costs of employing fixed factors of production in the SR, EG
overheads, rent, maintenance on buildings etc. These costs do not vary with output

• Variable costs ­ the costs when employing variable factors of production in the SR,
EG labour + raw materials, do vary w/output

• In LR, economics of scale are where LR AVG costs fall as output rises, due to the
efficiency gains that can be made by increasing the scale of factors that are fixed in
the SR

• Minimum efficient scale (MES) ­ Smallest firm size that can benefit from the min. LR
AVG costs/full economies of scale. In industries with a high MES, this acts as a large
barrier to entry + makes competition hard as new firms will quickly die due to lack of
price competitiveness Technological change + its impact: Positive aspects:

• Internet increases transparency, EG price comparison websites such as 'money
supermarket' or 'compare the market'. Markets get closer to perfect information +
therefore perfect competition

• Has lead to lower barriers to entry, increasing contestability of markets. Internet
startups + e­businesses are relatively quick + easy + cheap to set up, EG facebook
(one of largest companies in world) set up in a university bedroom. This means that
the threat of competition is greater than ever, as new entrants can be quickly +
cheaply set up.

• EG the dramatic fall of Myspace, toppled by Facebook, shows that digital/online
markets are very contestable and often fast­moving when a new, better competitor
comes along.

• Internet makes education available to all with a computer, EG Khan Academy, a free
online educational site, is used by the children of Bill Gates, one of the richest people
in the world, but could equally be used by a very poor person.

• Productivity increases as technology provides new + more efficient ways of working
and doing things. Allows prices to fall over time, despite quality increases, EG the
price of computers/tablets/smartphones/TVs etc have all fallen over time, despite
increases in computing power.

• New, cheaper services with more competition, EG Uber in the taxi market, which
provides a cheaper alternative to the classic London black cab. Negative aspects:

• Often people still use the local shop/most convenient + price comparison hasn't
permeated all markets to the same extent. It is inconvenient when shopping for
weekly food shop to compare all the different prices of different items, so instead
people choose the most convenient supermarket most of the time.

• Internet may also cement monopolies + reduce competition. EG Google has a near­
monopoly in search engine market (with 90% of UK online searches) + arguably uses
this power to gain an unfair advantage in other markets, such as online advertising or
email, pushing its own products ahead of competitors. EG Microsoft sued for abuse of market power, as they used advantage in software to push their own internet browser
with a free installation..

• Huge first mover advantage associated with the internet means first firm to market can become hugely dominant. EG when all companies use Microsoft Word for word
processing, it becomes difficult to switch brands after their first mover advantage, due
to compatibility issues.

• New technology often initially expensive + not available to all firms (capital equipment
+ machinery + automation is very expensive initially to install) so in SR may reduce
competition if only largest firms can afford to adopt new technology. EG new
expensive robotics + automotive technology which decreases marginal costs
significantly BUT requires a very expensive initial outlay, making it available only to
largest firms, who then cement their advantage + increase their dominance further as
they can afford to set much lower prices.

• Digitisation of much of the economy fundamentally changes cost curves. Marginal
cost often zero with the rise of digitised information. EG digital music or e­books are
free to reproduce after their initial production; it costs iTunes nothing to sell an extra
song. But, if profit.max is MC=MR, and MC=0, then MR=0, so not profitable to run the business conventionally.

• 'Creative destruction' + the disruptive nature of technical change + innovation leads to
old, uncompetitive + outdated firms going out of business as they're displaced by
newer rivals. This often creates ST dislocation + unemployment for out­of­date
workers.

• Structural unemployment may result due to skills mismatches, as new technology
requires new skills Perfect Competition:

• Normal profit ­ Minimum profit to keep incumbent firms in the market, normal profit is
incorporated as a cost of production

• Supernormal profit ­ Any profit above normal profit

• A perfectly competitive firm has the following characteristics:

• Large no. of buyers + sellers

• Perfect information (inc. prices, costs of production etc)

• Able to sell as much as they want at the ruling market price

• Unable to influence ruling market price, 'price­taker' (i.e. grain of sand idea)

• Homogenous/identical products (perfect substitutes)

• No barriers to entry or exit in the LR

• Perfect competition is unrealistic, but a useful benchmark against which to judge other market structures + a close approximation to some markets (notably markets like the
stock market or FOREX)

• BUT even in the supposedly ultra­efficient, perfectly competitive stock market, Robert
Shiller, Nobel winning economist, has shown that the large price variations present in
the stock market cannot be accounted for by changes in fundamentals. Psychology +
herd behaviour often drives market volatility, so is this perfectly efficient?

• LR equilibrium for a perfectly competitive firm shown below. In SR, supernormal profits can be made, but this attracts new firms, shifting market supply outwards, leading to a
lower market price + therefore the AR=MR curve shifts down until the point where
normal profit only is made.

• SR supernormal profits in a perfectly competitive market always attracts new
competitors/firms into the market until the price is driven down to the point of normal
profits in the LR.

• Supernormal profit is the difference between the AR + AC at the given level of output,
and normal profits are made where average costs = average revenue.

Monopoly:

• A pure monopoly, in contrast, has only one firm/100% market share

• Market demand curve is the monopolist's demand curve, as the monopoly is the
industry

• Can influence ruling market price due to large market power, a 'price­maker'

• In monopoly, market demand curve is monopoly AR curve, AR = D

• MR curve always twice as steep as AR curve

• Due to the downward sloping AR curve, MR must be below AR at all times,
descending twice as steeply.

• Monopoly in equilibrium shown below. Output is determined at MC=MR, and the price is the dotted line at this level of output taken up the demand curve, or AR curve, which is the maximum the monopolist can charge at this quantity.

• SR = LR, with no distinction in monopoly, due to the very high barriers to entry + exit
which mean new competitor firms can be kept out of the market + supernormal profits
made in the long­run as well as the short­run.

• Intellectual monopolies with patents + subsequent supernormal profits shown in the
pharmaceutical industry, for example, where EG Pfizer has a huge 43% profit margin
due to the intellectual, legal barriers to entry.

• Monopoly leads to a lower output + higher price than would be the case under perfect
competition

• EG

Google has 90% of UK online searches, 90% of search engine market and is very
close to a true monopoly in terms of market share.

Sources of monopoly power/barriers to entry:

• Natural monopoly/economies of scale ­ Only room in the market for one firm to
benefit from the full economies of scale, with a high minimum efficient scale, so
competition wasteful due to duplication + higher AVG costs. EG utilities
companies such as water + gas, where duplicating energy infrastructure with
competition would be wasteful. In a natural monopoly, competition impossible
anyway, as new firms will have much higher AVG costs and quickly go out of
business

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