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Microeconomics Notes

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Size and Growth of Firms Firms - business organisations where decisions are made (engaged in the production of goods and services)

They combine factors of production (scarce resources) in order to produce output that consumers need and want

Profit - the excess of a firm's revenue over its costs
Normal profit - the minimum level of profit necessary to keep firms in the market. Firms must make normal profit to stay in production; economists treat normal profit as a cost of production

Normal profit is shown on the firm's average cost curve (costs such as rent and wages)

Supernormal profit - also known as abnormal profit is when a firm is profit maximising and exceeding their normal profits Supernormal profit acts as an incentive for new firms to enter the market. The size of a firm can be measured by:

Sales turnover

Numbers employed

Market share

Stock market value

The value of assets

Objectives of Firms Profit maximising - businesses possess the information, market power and motivation to set a price and output that maximises profits Divorce between ownership and control - the people who control the firms are not the same as the managers (shareholders do not have much influence) - the managers have a lot of freedom to set their own objectives

The only power the shareholders have is to attend the Annual General Meeting

Managers may seek to gain higher salaries, greater prestige or satisficing (making only satisfactory profits and have more leisure time)

Principle agent problem - people (principle) have to employ others (agents) to do their work, however the agent has more information than the principle and therefore may act in a way that benefits their own interests

Principles therefore have to monitor their agents closely and give incentives for agents to behave in the principles interest

** However, some of the managerial objectives may conflict with shareholders' objectives

Higher salaries is a incentive to work harder which increases productivity within a firm and subsequently leads to higher profits

Growth of the firm (economies of scale) can lead to higher profits, higher dividends for shareholders (their share in the firm) and subsequently this could increase the value of the firm's shares

Satisficing - a firm deals with many interest groups all with their own objectives - the overall objectives of a firm will be a combination of these various objectives, therefore the firm aims to satisfice these different groups and still function

What is the role of profit in an economy?
Profits influence the allocation of resources:

1. Finance for investment - profits remain the most important source of finance for capital investment

2. Market entry - rising profits send signals to other producers within a market - eg. Samsung now produce a tablet after the success of the iPad Rewards for risk taking - prospects of high profits provides an incentive to take risks and produce new products

Eg. The iphone was a large risk to produce due to extremely high costs - however the prospect of supernormal profits makes it worthwhile investing in the business rather than saving the money

Keeping firms in the market - high profit ensures more competition within the market - firms develop new products in order to compete with other firms

High profit also ensures more stability and prestige within a market (brand loyalty) and ensures that firms respond quickly to changes in market forces

Incentives - the prospect of high profits encourages firms to innovate, as well as increasing the possibility of a pay rise for workers, encouraging them to increase their productivity

High profits acts as an incentive for investors to invest into a firm or market

Improving resource allocation - resources move to markets that are most profitable (eg. Smart phones are extremely profitable) - profits act as a signal and therefore attract new firms into the market

Case Study - John Lewis In John Lewis, all employees have a stake in the company (all have shares) and therefore all workers have a say in the way the firm is run through councils (certain level of influence)

They offer high wages (£10 an hour) and good work conditions to act as an incentive to work harder

Medium sized firm (approximately 80,000 employees) that are very successful even in the recession - as their workers are also partners, they effectively avoid the 'principle-agent problem'

Price Discrimination A firm price discriminates when it charges different prices to different consumers for reasons that do not reflect cost differences

Market segmentation - splitting the market according to age, income or other factors

It is practised by any firm with price setting power (oligopolies and monopolies)

Linked to a consumer's willingness to pay


Must have price setting power - therefore must operate in an imperfectly competitive market

Must be at least 2 consumer groups with different price elasticity of demand - eg. Rail fares at peak times is inelastic, off peak is elastic

Firm must be able to identify consumers in different groups and charge different prices

Firm must prevent consumers in one group selling to consumers in the other

Advantages of price discrimination

1. Some consumers are brought into the market that might have not been able to purchase the good beforehand

10% student discount for students may allow some consumers to purchase goods they wouldn't have otherwise been able to

2. Higher output than under a single price monopoly - charge extortionate prices for inelastic goods

High prices for rail fares at peak times - for example, Manchester to London at 8 am

3. Profits may finance research and development projects - innovation in the market

4. Profits may help to cross-subsidise other activities - for example, doctors may charge lower income patients less - supported by higher charges for wealthier patients

Consumer Surplus Consumer surplus is a measure of the welfare that people gain from the consumption of goods and services

It is the difference between the total amount that consumers are willing and able to pay, and the total amount that they actually pay

The level of consumer surplus is shown by the area under the demand curve and above the market price

Consumer surplus means that nearly all consumers are paying less than they would have been willing to pay

Under price discrimination, all consumers are changed under different prices - this causes consumer surplus to fall

Price discrimination removes consumer surplus from consumers and transfers it to producers

Producer Surplus Producer surplus is a measure of the producer welfare - the difference between what producers are willing and able to supply a good for, and the price they actually receive

Level of producer surplus is shown by the area above the supply curve and below the market price

What is a contestable market?
Contestable markets are imperfectly competitive markets in which firms face real and potential competition - pool of potential entrants in a market with no barriers to entry

Threat of "hit and run entry" from new rivals keeps the industry operating at a competitive price and output - firms enter the market when profits and demand is high

Absence of "sunk costs" - entry and exit is perfectly costless

If an industry is contestable - incumbent firms may be forced to act as if they are in competition - make only normal profits due to the threat of "hit and run entry" Example - football match burger vans are an example of a contestable market, there are no sunk costs (sell the van and get your money back) and there is a large pool of potential entrants as it is profitable, cheap to set up and requires very little skill to run Sunk costs - costs which are irrecoverable should the owner of a firm decide to leave the market - they represent a barrier to entry from entering certain markets

Making markets more contestable

1. De-regulation - reducing legal barriers to entry to liberalise (open it up to competition) a market

• Example - the bus industry de-regulated 20 years ago, do not need council permission to set up a bus company

2. Tougher competition laws - acting against predatory behaviour by existing firms/ tough rules against cartels

• Example - price cutting to stop new firms entering the market

3. Technology - changing nature of technology has brought down entry costs in some markets

• Example - ability to sell on websites such as EBay with very little barriers to entry

How does growing contestability affect efficiency in the market?
Allocatively efficient - more allocatively efficient in order to beat the competition - they must provide the goods that consumers demand the most (inelastic demand) and prevent hit and run entry

As prices fall in a contestable market - they fall to 'P = MC' - firms are making more normal profits which increases allocative efficiency

Productively efficient - more productively efficient in an attempt to gain economies of scale in the market - increase output and reduce costs at the same time (reduce prices in a competitive market)

Short Run Costs A period in which the enterprise has decided its 'capacity size' and therefore can only increase output by increasing the use of other factors of production - there is at least one fixed factor of production (usually land) Total cost = fixed costs + variable costs Average total cost = total cost / output Marginal cost = addition to total cost Average fixed costs = total costs / output
*Average costs will fall when both average fixed costs and average variable costs are falling
- but will rise when the fall in average fixed costs is less than the rise in average variable costs

Diminishing Returns Theory that relates to the additional output that result from marginal increases in a factor of production, when it is combined with a fixed factor of production Example - suppose additional workers are added to a fixed plot of land. Initially, output would increase due to teamwork, ultimately as more and more workers are employed, the marginal additions will begin to diminish

Long Run Costs A period when the enterprise can alter its scale of plant - all factors of production can become variable

As the scale of plant increases, the enterprise may experience economies of scale - average total cost will fall in the long run

Increasing returns to scale - when an increase in all factors of production leads to a more than proportional increase in output

Decreasing returns to scale - when an increase in the input of all factors leads to a less than proportional increase in output

Economies of Scale Increases in productivity as a firm increases its size and scale Specialisation - specialist machinery will allow firms to increase capital and labour productivity thus lowering their long run average costs Indivisibilities - firms can increase their productivity by using more efficient capital - for example, assembly lines for mass-produced cars increase the output of firms more efficiently Linkage of processes - larger levels of output, the more efficient is the linkage of processes because a firm with an output of 40 units would have capacity under utilised

Marketing economies Bulk buying - large firms benefit from bulk buying and gaining discounts. They use their huge power to gain discounts as they threaten companies to take away their business Transport - large firms use lorry fleets to transport goods and reduce their cost of transportation

Financial economies Credit rating - large firms have higher credit ratings so they can obtain finance more easily and cheaply

Banks consider large successful firms to be more reliable due to their established reputation and prestige

Managerial economies Research - larger firms have the resources to afford extensive research and development projects which encourages innovation within the market

Due to their stability, larger firms also have more risk-bearing economies

Diseconomies of Scale The theory that firms can become too large and subsequently very difficult to manage - organisation, coordination and decision making problems associated with extremely large firms Economies of concentration Too many firms locate in one area therefore labour becomes scarce and firms are forced to offer higher wages in order to attract labour from further afield Economies of scope When a firm increases the number of different and diverse goods that it produces, this can cause a fall in demand

As the firm's management, structure, design, marketing and distribution costs are spread over a large product range - this reduces the LRAC of each product

Economic Efficiency Economic efficiency relates to how well a market or the economy allocates scarce resources to satisfy consumers

Efficiency occurs when society is using its scarce resources to produce the highest possible amount of goods and services that consumers want to buy

Allocative efficiency - when the value that consumers place on a good or service equals the cost of the resources used up in production - when a firm or industry is allocating resources to produce the goods and services that people want

Condition required for allocative efficiency is PRICE = MARGINAL COST - when this happens, economic welfare is maximised

Productive efficiency - refers to a firm's costs of production - it is achieved when the output is produced at minimum average total cost (when a firm is exploiting most of the available economies of scale)

Productive efficiency exists when producers minimize the wastage of resources in their production processes

Dynamic efficiency - occurs over time and it focuses on changes in the amount of consumer choice available in markets together with the quality of goods and services available

Economies are dynamic and respond to technological innovations and new suppliers entering the market offering new products and improving consumer choice

Pareto optimality - optimal allocation of resources using scarce resources for society - 'makes one person better off, without making someone else worse off' Cross (X) inefficiency - a failure to control costs Example - monopolies are often reluctant to drive down costs due to little competition in the market acting as an incentive

Large firms may have other objectives rather than simply to maximise profits and reduce costs - more leisure time (satisficing) or higher salaries

Firms may be X-Efficient if they employ specialist employees who are experts in their field and have large human capitals - furthermore, if they can bulk buy and cut costs

Firms may be X-Inefficient if managers do not want to profit maximise and have other objectives within the firm

In theory, the private sector is meant to be more efficient than the public sector due to highly skilled management, investment and infrastructure - however, the company G4S rejects this theory

Freeview - an example of allocative efficiency Due to technological advancements, it is legally much easier to get a slot on freeview television (removal of legal barriers to entry - no legal monopoly such as the BBC)

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