Edexcel

A level Economics - A
Theme 3: Business behaviour and the labour market

3.1 Business growth

• 3.1.1 Sizes and types of firms

• 3.1.2 Business growth
• 3.1.3 Demergers

3.2 Business objectives

• 3.2.1 Business objectives

3.3 Revenues, costs and profits

• 3.3.1 Revenue
• 3.3.2 Costs
• 3.3.3 Economies and diseconomies of scale
• 3.3.4 Normal profits, supernormal profits and losses

3.4 Market structures

• 3.4.1 Efficiency
• 3.4.2 Perfect competition
• 3.4.3 Monopolistic competition
• 3.4.4 Oligopoly
• 3.4.5 Monopoly
• 3.4.6 Monopsony
• 3.4.7 Contestability

3.5 Labour market

• 3.5.1 Demand for labour

• 3.5.2 Supply of labour
• 3.5.3 Wage determination in competitive and non-competitive markets.

3.6 Government intervention

• 3.6.1 Government intervention

• 3.6.2 The impact of government intervention

 3.1 Business growth

Types of firms
Profit organisations
Most firms aim to make profit to be distributed amongst the shareholders /
owners:

• Public limited companies (PLCs) are listed on the stock market and can
raise funds from issuing shares. They could lose control of the firm to a
takeover.
• Private limited companies (ltd) are owned by a small number of people
who can retain control, but they may have greater difficulty raising finance.
• Sole-trader / partnership - These are small firms run by one person, or a
partnership of a few people. In recent times, there has been a growth in the
number of small firms. These have greater flexibility and can cater to a
niche market.

Non-profit organisations
These are organisations which have similar functions to firms, but have non-profit
making objectives. They may include:

• Registered charities - Organisations like Oxfam, who run charity shops to

raise funds for charitable projects.
• Housing associations – Organisations which seek to offer affordable
housing without making profit.
• Building societies – Financial organisations owned by their members and
they do not make a profit. Any funds left over are used to lend more
mortgages. In the past few decades, many mutual building societies
became private banks and were able to seek profit.
• Co-operative societies – Organisations owned by members (workers,
consumers and management).

Public sector organisations

These are organisations which are run with public (government) money e.g. the
Highways Agency, which manages UK roads. They do not exist to make profit, but
provide a public service.
Some organisations, like Network Rail, are a mixture of private sector and public
sector backing.
Private sector organisations

These are firms and organisations which are owned by individuals and not
connected to the government. Most firms are private sector organisations.

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Principal-agent problem
In some firms, there is separation of ownership and control:

• For example, a PLC, such as Tesco, will be owned by shareholders.

However, shareholders are not usually involved in the day-to-day running
of the company. This is left to workers and managers.
• This means there is separation of ownership and control, which can be
referred to as the principal-agent problem.
• The owners will wish to maximise profits, to increase their dividends.
However, managers and workers who are involved in the company may
not share this objective. They may prioritise other objectives, such as:
o Getting on with fellow staff members.
o Enjoying work and having a good time.
o Not trying too hard.
o Being concerned with prestige and size of the firm.
• Therefore, when there is separation of ownership and control, managers
may do enough to keep owners happy, but then maximise these other
objectives.
• Therefore, they may avoid decisions which would potentially increase
profit e.g. sacking under-performing workers.
• See also: Profit satisficing in business objectives.

Why firms grow

There are several reasons why firms grow in size:

• Profit - Growth in the size of the firm enables greater scope for profit.
• Market share / influence - Growth in the size of the firm enables higher
market share and more influence in the market.
• Growing market - If their product becomes in greater demand, the firm
will expand. For example, the growth of Google is closely related to the
growth in importance of the internet.
• Prestige - Managers may prefer to work for a more successful, larger firm,
which gives scope for a higher salary and greater job satisfaction.
• To benefit from economies of scale - If a firm has high fixed costs,
increasing their size enables lower average costs, greater efficiency and
lower prices.
• Mergers - In many industries with high fixed costs e.g. the car industry
and aeroplane manufacture, we have seen mergers between firms to
create bigger organisations able to benefit from economies of scale.

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How businesses grow
1. Organic growth
Organic growth involves internal expansion, with the firm increasing its sales and
market share. This can involve:

• Investing in new productive capacity / technology.

• Marketing campaigns which increase demand for products.
• Creating new product lines related to existing products.
• Becoming more competitive e.g. lower prices, which capture market share.

Advantages of organic growth

1. As the firm increases in size, they will be able to benefit from economies of
scale, which lead to lower average costs and greater efficiency.
2. The firm will be making use of its existing expertise and investment.
3. The firm will know the market and is in full control of the growth.

Disadvantages of organic growth

1. The firm may soon reach the limits of market saturation and be unable to
grow any more.
2. It can be quite time-consuming to rely on increasing market share,
especially if the market is very competitive.
3. It may lack access to resources, location, or the necessary skills to gain
different stages of production.

2. External Expansion
This involves a merger / integration with another firm.

• Horizontal merger / horizontal integration - This occurs when two

firms at the same stage of production merge e.g. Guinness and Heineken,
two beer-brewing companies.
• Vertical merger / integration - When two firms at a different stage of
production merge. For example, a company who produces beer could buy
a chain of pubs to sell the beer.
• Forward vertical merger - This is when a firm acquires another firm at
the next stage of production, e.g. a firm like Ford which manufactures cars
could purchase a car sales room.
• Backward vertical merger - When a firm acquires another firm at a
previous stage of production e.g. a clothes retailer buying a manufacturer
of clothes, or a beer producer buying a farm which produces hops
(ingredient used for brewing beer).

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Advantages of vertical integration
1. It gives the firm greater control over supplies, or a guaranteed place to sell
their goods.
2. It gives the firm greater market power. For example, if Guinness owns
pubs, it can restrict the sale of competitor beers, thus increasing their sales
and profits.
3. If there is a shortage of supplies, it is in a better position. For example, a
poor coffee harvest could lead to a higher price for coffee but, if Starbucks
own coffee plantations, they will benefit from the high price of coffee and
can ensure they get the limited supply of coffee beans.

Disadvantages of vertical integration

1. The firm may lack expertise to manage a different stage of production. For
example, a successful coffee shop brand (e.g. Starbucks) may not realise
what is required to grow coffee beans.
2. The firm may become too big and unwieldy. The firm may suffer from
diseconomies of scale, due to the larger infrastructure and increased
bureaucracy within the bigger firm.
Conglomerate merger / integration.

• When two unrelated firms merger e.g. Time Warner (films) merging with
AOL, an internet firm.
Horizontal mergers – see: mergers p.7

Constraints on business growth

Some firms remain small for a variety of reasons:

• Lack of ambition - Some small family firms / sole traders may not want to
expand, because one shop is satisfactory for their needs. Not all firms aim
for profit maximisation or sales maximisation. People may feel quality of
life may be maximised by keeping a firm small and manageable.
• Too much competition - Some markets are very competitive, making it
hard to increase market share.
• Choice - In some markets, like clothes, there are many niche market
segments. Being the cheapest clothes producer is not enough, because
some consumers will never want to buy the cheapest clothes, preferring
the most exclusive.
• Government regulation - Governments can intervene, to prevent the
growth of monopoly power. For example, the Competition Commission
would block a merger between Tesco and Waitrose.
• Lack of access to finance - Many small firms may struggle to raise finance
for investment and expansion.

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 • Size of the market. -Many firms are limited by the market they are in.
Firms who produce niche products, such as clothes for very tall people,
will only have a small market. The only way to grow is to diversify into
related markets.
• Product life cycle - Many firms see good growth when a product is the
phase of expansion. However, there often comes a time when the product
(e.g. VHS and CDs,) becomes superseded by another technology and so
demand will start to fall.
• Access to key locations - A new airline may struggle to grow, because it
has difficulty getting landing slots at Heathrow airport. This is an example
of vertical constraints to growth.
• Legal barriers - A legal patent may prevent other firms from entering a
certain market. For example, a drugs company may be unable to grow,
unless it can get the necessary patents.
• Tax incentives - If a firm grows in size, it may lose the benefits of
remaining a small firm (e.g. lower corporation tax, VAT and grants from
government).
• Diseconomies of scale - Increasing size may lead to higher average costs
and greater inefficiency, due to difficulties of managing a large firm.

Demergers
Demergers occur when a firm splits up into two smaller entities. For example, the
chemicals giant, ICI, decided to demerge into two firms, new ICI and Zeneca.
Reasons for demergers can include:
1. Reduced bureaucracy - Splitting a firm into smaller parts can enable
reduced bureaucracy and make it easier to control, co-ordinate and
motivate constituent parts.
2. Specialisation - Demergers can enable a firm to concentrate and
specialise in one particular area e.g. after the split, Zeneca became a
pharmaceutical firm, with ICI concentrating on more traditional chemicals.
3. Greater motivation - Sometimes, workers and managers feel more
motivation when working for a small firm, with clearer defined goals.
4. Diseconomies of scale - Large firms can start to see rising long run
average costs, because of the greater inefficiency found in big firms e.g.
difficulty of communication in large organisations.
5. Threat of takeover - If a large firm is underperforming, it may face the
threat of a hostile takeover. A demerger can be part of a process to
increase efficiency, profitability and prevent a takeover.
6. Government competition policy - If a firm gains too much monopoly
power, it may face regulation from government competition policies. A
demerger may enable it to escape regulation of monopoly power.

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Impact of demergers
On workers

• A demerger may lead to rationalisation and getting rid of surplus workers,

causing some workers to be made redundant.
• On the other hand, it may also enable some workers and managers to have
greater influence and responsibility in the newly-created firms.
On businesses

• A demerger may enable the separate firms to become more successful.

They can now concentrate on a smaller, narrower field, and they could face
less organisational resistance than you may find in a large firm.
• The new firms could also struggle, because they have less finance and
resources for research and development. There is no guarantee that
workers will respond well to being split up. It depends on whether they
feel part of the process and whether they are committed to the new firm.

On consumers

• Consumers may not see any immediate effect, as the products will still be
the same. However, if the new firms are able to become more innovative
and dynamic, consumers may gain from new products in the long-run.
• Also, the demerger may increase competition in the market, leading to
lower prices for consumers.
• However, there is a risk that the newly-formed companies will be liable to
tacit collusion and so the gains from competition may be less than hoped.

Evaluation

• It depends on the type of demerger e.g. ICI and Zeneca were separate
market segments, so the demerger had certain logic. However, for a firm
like Google, it may be harder to break up into smaller segments.
• It may be easier for the government to regulate monopoly power, rather
than break up a firm.
• It depends on how the firm is managed. A firm may find it can delegate
authority and motivation, by splitting the firm into smaller parts, without a
formal demerger.
• A firm who gains monopoly power may be successful, because it is actually
efficient and innovative.

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Business objectives
1. Profit maximisation
In economics, we usually assume firms aim to maximise total profits. This may be
short run profit maximisation, or it may involve a long run strategy to increase
profits.
Benefits of maximising profit

• Higher salaries for managers and workers.

• Higher dividends for shareholders and reduction in the risk of a hostile
takeover.
• Encourages firm to be efficient and to keep looking at cutting costs.
• Higher profit enables more resources to invest in future projects and
safeguards the long-term success of the firm.

2. Sales Maximisation
Firms often seek to increase their market share, even if it means less profit. This
could occur for various reasons:
• Increased market share increases their monopoly power and may enable
them to put up prices and make more profit in the long run. Increasing
market share may force rivals out of business.
• Managers prefer to work for bigger companies, as it tends to lead to
greater prestige and higher salaries.
• Higher sales increases influence in society. For a firm like a newspaper,
they may have a desire to influence political views and so consider market
share more important than profit.

3. Social / environmental concerns

A firm may incur extra expenses to choose products which don’t harm the
environment, or choose products not tested on animals.
• This has actually proved quite a good marketing strategy e.g. for firms like
the Body Shop.
• Organisations like the Co-op have a different structure to share profits
amongst consumers and workers.

4. Profit satisficing / Principal agent problem

In many firms, there is separation of ownership and control. This is a problem
because although the owners may want to maximise profits, the managers have
much less incentive to maximise profits, because they do not get the same
rewards.
• In this situation of separate ownership and control, managers may create a
minimum level of profit to keep the shareholders happy, but then
maximise other objectives, such as enjoying work and getting on with staff.

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 • To overcome the problem of profit satisficing, the firm can give workers
and managers performance-related pay and share options. This gives
workers an incentive to think like shareholders and maximise profits, and
it could overcome the x-inefficiency of workers without incentives.
• It depends on whether firms can give workers a reason to feel motivated to
work hard; this depends on several factors, such as corporate culture.

Diagram showing different objectives

• P1, Q1 – Profit maximisation - because it is the output where MR=MC

• P2, Q2 – Revenue maximisation - because it is the output where MR=0
• P3, Q3 – Marginal cost pricing - P=MC (allocative efficiency)
• P4, Q4 – Sales maximisation - The maximum sales a firm can make whilst
making normal profit (AR=AC).

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3.3. Revenue, costs and profits
• Total revenue (TR) - This is the total income a firm receives. TR = price ×
quantity.
• Average revenue (AR) = TR / Q.
• Marginal revenue (MR) - The extra revenue gained from selling an extra
unit of a good.

Example of Price, TR, AR and MR

Q P TR AR MR
1 10 10 10 10
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
5 6 30 6 2
6 5 30 5 0
7 4 28 4 -2

What is the marginal revenue of selling the fifth good?

• At a quantity of 4, the total revenue is 28.

• At a quantity of 5, the total revenue is 30.
• The gain in revenue is 2 – this is the marginal revenue of the fifth good.

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Revenue maximisation and elasticity

• When marginal revenue is positive, it means the firm is increasing its total
revenue.
• If MR is negative, then total revenue is decreasing. Therefore, revenue is
maximised when MR = 0.

Revenue and elasticity

• On a straight demand curve, the elasticity of demand varies. Initially, PED
is elastic. This is because the % change in QD is greater than the % change
in price.
• As price falls, revenue increases (MR>0) because demand is price elastic.
• However, later, the demand curve becomes inelastic. The % change in QD
is less than the % change in price. Here, a fall in price leads to a decline in
revenue, because demand is price inelastic.
• Where MR= 0, PED = 1 (unitary elasticity). At this point, changing price
doesn’t change total revenue; the % change in price is the same as the %
change in QD.

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Profit
• Profit = Total revenue (TR) – Total costs (TC) or (AR – AC) × Q.
• Normal profit - This occurs when TR = TC. This is the breakeven point for
a firm. It is the minimum profit level necessary to keep the firm in the
industry in the long run.
• Supernormal profit - This occurs when TR > TC. This is profit above the
breakeven point.
• Operating profit - This occurs where AR >AVC. When average revenue is
greater than average variable cost, the firm is making a contribution
towards its fixed cost.

Whether a firm will produce

This diagram shows a firm’s short run ATC and short run average variable costs
(AVC) The price will set the average revenue (AR) the firm gets.

• @ P1 - AR > ATC. The firm is making supernormal profits
• @ P2 - AVC< AR< ATC. The firm is making an operating profit, and is
covering its variable costs, but not all its total costs. Therefore, in the short
run, it is best to keep producing, because it has already paid for its fixed
costs and it is making a contribution to its variable costs.
• @ P3 - AR=AVC. The firm is just covering its variable costs. This is known
as the shutdown point, as anything less is an operating loss.
• @ P4 - AR < AVC. The firm is making an operating loss and will shut down.

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Profit maximisation
Profit maximisation will also occur at an output where MR = MC.

• If MR > MC, total profit rises. When MR > MC - the addition to total revenue is
greater than the addition to total cost
• If MR < MC, total profit falls.
• Profit is therefore maximised at Q = 5, Where MR=MC.
• This diagram assumes that a firm can know its marginal cost and marginal
revenue.
• However, in the real world, they may not know exactly and make a best
approximation.

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Costs
• Fixed costs: Costs that do not vary with output e.g. the cost of a factory.
• Variable costs: Costs that do vary with output; e.g. electricity and
materials.
• Total costs: Fixed + variable costs.
• Marginal cost: This is the cost of producing one extra unit e.g. MC of 4th
unit in table is (1900-1550) = 350
• Sunk Costs: These are costs that are not recoverable e.g. advertising.
• Average Total Cost (ATC) = TC / Q
• Average Variable Cost (AVC) = VC / Q
• Average Fixed Costs (AFC) = FC / Q

Examples of costs
Q FC TC VC MC ATC
0 1000 1000 - -
1 1000 1200 200 200 1200
2 1000 1300 300 100 650
3 1000 1550 550 250 516.67
4 1000 1900 900 350 475

Diagram of Costs

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Diminishing marginal returns
This occurs when employing extra workers leads to declining productivity.

• Total product (TP) - This is the total output produced by all workers.
• Marginal product (MP) -This is the output produced by an extra worker.

Diagram showing diminishing returns

Q of workers MP TP MC
1 2 2 10
2 4 6 5
3 6 12 3.3
4 8 20 2.4
5 10 30 2
6 8 38 2.4
7 5 43 4

• The first worker adds 2 goods. If a worker costs £20, the MC of those 2
units is 20/2 = 10.
• The 3rd worker adds 6 goods. The MC of those 6 units is 20/6 = 3.3
• The 5th worker adds an extra 10 goods. The MC of these 10 is just 2.
• After the 5th worker, diminishing returns sets in, as the MP declines. As
extra workers produce less, the MC increases.

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Diminishing returns explained

• Diminishing returns occur in the short run, when one factor is fixed e.g.
capital.
• If the variable factor of production (labour) is increased, there comes a point
where it will become less productive.
• This is because if capital is fixed, extra workers will eventually get in each
other’s way, as they attempt to increase production.
• Consider a small café with limited space – 5 workers will start to get crowded.
• When diminishing returns occurs, there will be a decreasing marginal
product (MP) and increasing marginal cost (MC).

MC and average costs

• Because of diminishing returns, we get a SRAC (short run average cost),
which is U-Shaped.
• The MC always cuts the SRAC at its lowest. When the marginal is higher
than average, SRAC will rise.
• When marginal is below average, the SRAC will fall.
• A firm can overcome these diminishing returns in the long term by
increasing the size of the factory (increase capital)

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Long run cost curves
In the long run, all factors of production (both capital and labour) are variable.

A firm’s long run average cost (LRAC) is constructed by using the point of
tangency with its short run cost curves. Therefore the LRAC is an envelope of all
the SRAC curves.

• At Q1, the firm has a certain size factory. If it tries to increase output in the
short run, it will come across diminishing returns. It can increase output
(e.g. getting workers to do overtime), but it becomes limited by the size of
the factory.
• However, in the long term, it is able to increase the size of the factory,
through investment. This enables a new SRAC at SRAC2. It can now
produce at Q2.
• Increasing the size of the firm is enabling lower long run average costs,
because of economies of scale.

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Economies of scale

• Economies of scale occur when long run average costs fall with increasing
output.
• Increasing output from Q1 to Q2 leads to lower average costs (P1 to P2).
• Therefore, increasing production leads to increasing returns to scale and
there is greater efficiency.
Internal economies of scale occur when an individual firm becomes more
efficient. Internal economies include:
1. Specialisation and division of labour. In large-scale operations, workers
can do more specific tasks. With little training, they can become very
proficient in their task and this enables greater efficiency. A good example
is an assembly line with many different jobs.
2. Bulk buying: If you buy a large quantity, then the average costs will be
lower.
3. Technical. When a firm benefits from increased scale of production. For
example, a large machine (e.g. blast furnace / combine harvester) would be
inefficient for small-scale production; for higher rates of production, the
firm gains a better rate of return.
4. Financial economies. A bigger firm can get a better rate of interest than
small firms.
5. Marketing. A national TV advertising campaign is more efficient for a
large firm.
6. Risk bearing. Bigger firms are able to diversify into different areas. This
gives them a greater ability to avoid an economic downturn.

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External economies of scale.
This occurs when firms benefit from the whole industry getting bigger. For
example, if the industry gets bigger, all firms will benefit from better
infrastructure, and access to specialised labour and good supply networks.

Diseconomies of scale
This occurs when long run average costs start to rise with increased output.
Therefore, there will be decreasing returns to scale. Diseconomies of scale can
occur for the following reasons:
1. Poor communication in a large firm with many workers.
2. Alienation: working in a highly-specialised assembly line can be very
boring, and therefore workers become de-motivated.
3. Lack of control: when there are a large number of workers, it is easier to
escape with not working very hard.

Minimum efficient scale

• The minimum efficient scale is the minimum point of output necessary to
achieve the lowest AC on the LRAC.

• If the MES was 10,000 cars a week, and the total industry demand was 40,000,
this would mean that the optimal number of firms would be 4.

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3.4 Market structures
Types of efficiency
1. Productive efficiency - Productive efficiency occurs when the economy is
on the production possibility frontier (PPF). It will also occur at the lowest
point on the firm’s SRAC curve.

2. Allocative efficiency - This occurs when goods and services are
distributed according to consumer preferences. This occurs at an output
where P=MC because, at this value, what the marginal benefit consumers
get is the same as the marginal cost

3. X-efficiency - This occurs when firms’ actual costs are as low as potential.
A firm exhibits x-inefficiency if it lacks incentives to cut costs and so its
actual costs are higher than they could be.

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 4. Efficiencies of scale - This occurs when a firm produces on the lowest
point of its long run average cost, and therefore benefits fully from
economies of scale.

5. Dynamic efficiency - This refers to efficiency over time. For example, if
firms introduce new technology, it enables them to reduce costs over time
and their average cost curve will shift downwards.
6. Social efficiency - This includes all external costs and benefits. This occurs
where social marginal cost = social marginal benefit.

Perfect competition
Perfect competition is a market structure where there are many firms and
competitive prices. Features of perfect competition include:
1. Many small firms.
2. Freedom of entry and exit; this will require low sunk costs.
3. All firms produce an identical or homogenous product.
4. All firms are price takers; therefore a firm’s demand curve is perfectly
elastic.
5. There is perfect information and knowledge for both consumers and
producers.

Examples of perfect competition include:

• Foreign exchange markets – sale of dollars and Euros.

• Many agricultural markets, e.g. potatoes sold at market
• Walking tourist guides around cities.

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Diagram for perfect competition

This diagram shows perfect competition in the long run equilibrium for both an
individual firm and the whole industry.

• The diagram on the right shows the industry supply and demand; this sets
the market price of P1.
• Individual firms are price takers; their demand curve is perfectly elastic.
Therefore D=AR=MR.
• Firms will maximise profits, where MR=MC (at output Q1).
• At this level of output Q1, firms make normal profits (because average
revenue (AR) = average costs AC).

Efficiency of perfect competition

1. Allocative efficiency - This is because the long run equilibrium (Q1)
occurs where P = MC.
2. Productive efficiency - This is because firms produce at the lowest point
on the SRAC.
3. X-efficient - Competition between firms will act as a spur to increase
efficiency and make sure firms use the best combination of inputs.
4. Resources will not be wasted through advertising, because products are
homogenous.

5. Economies of scale. Because there are many small firms, they cannot
benefit from economies of scale and may have higher LRAC.
6. Dynamic efficiency. Firms have no supernormal profit to invest in R&D
and therefore, may lack dynamic efficiency.

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Perfect competition in the short run

Impact of higher demand in perfect competition

• If there is an increase in market demand (D2), there will be an increase in
the market price to P2.
• Therefore, the individual demand curve, and hence AR, will shift upwards.
• Firms will now maximise profits at Q2 (where MR=MC).
• This will cause firms to temporarily make supernormal profits (AR-AC) ×
Q2.
• However, there is perfect information, so other firms will know this
market has supernormal profits.
• There are no barriers to entry, so this will encourage new firms into the
market, until normal profits are made and prices fall back to P1.

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Impact of higher costs in perfect competition

• If firms had a rise in AC, they would start to make a loss.
• But, if firms make a loss, they will close down, causing the market price to
rise until the industry is profitable again.
• Therefore, in the long run, firms in perfect competition will make normal
profits (AR=AC).

Disadvantages of perfect competition

1. No scope for economies of scale. This is because there are many small
firms producing relatively small amounts. Industries with high fixed costs
would be particularly unsuitable to perfect competition.
2. Undifferentiated products. These can be boring, giving little choice to
consumers.
3. Limited investment. Lack of supernormal profit will make investment in
R&D unlikely; this would be important in an industry such as
pharmaceuticals.
4. Limited incentives. With perfect knowledge, there is no incentive to
develop new technologies, because it would be shared with other
companies.
5. Externalities. If there are externalities in production or consumption,
there is likely to be market failure without government intervention.

How realistic is perfection competition?

• In the real world, it is hard to meet all the criteria, such as perfect
information and freedom of entry and exit.
• However, some markets come closer than others. Many markets can be
considered ‘competitive’, even if not quite matching perfect competition.
• These competitive markets with many firms will have a similar outcome to
perfect competition i.e. low prices and low profits.

Internet and competition

The internet has increased the number of industries which are closer to perfect
competition because:

• It is very easy to check prices (perfect information).

• The internet has helped to reduce costs of entering an industry; you don’t
need a big shop, but can spend a small amount on a website.
• Many firms are producing similar goods.
• However, the internet is not universally increasing competition. Some
firms have gained strong market power through dominating an aspect of
the internet, such as Google and Facebook. It would be difficult to
challenge these firms, who have the benefit of being the first to dominate.

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Monopolistic competition
Monopolistic competition is a market structure with the following features:

• Many firms.
• Imperfect knowledge, but can spot firms making supernormal profit.
• Freedom of entry and exit. Low barriers to entry.
• Similar goods, but with brand differentiation.

Examples include restaurants, hairdressers and clothing retailers.

Short run monopolistic competition

• Firms in monopolistic competition produce differentiated products; they
have an inelastic demand curve. This enables them to set a profit,
maximising price similar to monopoly.
• The firm maximises profit, where MR = MC. This leads to supernormal
profit, because AR > AC.
• They are allocatively inefficient (P>MC) and productively inefficient (not
lowest point on AC curve), in both the short run and long run.

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Monopolistic competition - long run

• In the long run, new firms are able to enter the market because there is
freedom of entry.
• As new firms enter, the demand curve for the initial firms shifts to the left,
until normal profit is made at P1
• (where AR=AC)

Limitations of the model of monopolistic competition

• Some firms will be better at brand differentiation and therefore, in the real
world, will be able to make supernormal profit. New firms will not be seen
as a close substitute.
• There is considerable overlap with oligopoly. The main difference is that
the model of monopolistic competition assumes no barriers to entry. In the
real world, there are likely to be at least some barriers, even if just through
brand loyalty.

Key difference with monopoly – In monopoly, there are barriers to entry. In
monopolistic competition, there are none. Therefore, in the long run, firms in
monopolistic competition will make only normal profit.
Key difference with perfect competition. In monopolistic competition, firms
produce differentiated products and, therefore, they are not price takers
(perfectly elastic demand). They have inelastic demand.

26
Oligopoly
An oligopoly is an industry which is dominated by a few firms. One definition of
an oligopoly is a five firm concentration ratio of more than 50%.

Features of oligopoly include:
1. Interdependence of firms: firms will be affected by how other firms set
price and output.
2. Barriers to entry (but less than monopoly).
3. Differentiated products. Advertising and non-price competition are often
important in oligopoly.

Concentration ratios
• A five-firm concentration ratio measures the market share of the five
biggest firms. A three-firm concentration ratio measures the combined
market share of the three biggest firms.

The five-firm concentration ratio of the UK supermarket share (2014) is:
1. Tesco 29%
2. Asda 17%
3. Sainsbury 16%
4. Morrison 11%
5. Co-op 6%
Total five-firm concentration ratio: 79%
• Note with 29% of market share, Tesco is considered a legal monopoly.
• In UK, a firm is said to be legal monopoly (monopoly power) when it has
more than 25% of the market share).

27
How firms in oligopoly behave
There are three main possible ways for firms in oligopoly to compete:
1. Price competitive / price wars – An oligopoly where firms try to gain
market share and where prices and profits tends to be low.
2. Stable prices / focus on non-price competition - The kinked demand
curve suggests prices will be stable and firms focus on non-price
competition.
3. Higher prices / collusion - If there are barriers to entry, firms may try to
maximise price through increasing prices. This may involve collusion.
The behaviour of firms in oligopoly depends upon factors such as:

• The objectives of the firms e.g. profit max or sales max.

• The degree of contestability e.g. amount of barriers to entry.
• Government regulation e.g. preventing collusion and price fixing.
• The nature of the industry e.g. is the industry in growth phase or decline?
A declining industry may be more prone to price competition, as firms try
to retain sales.

Game theory
• This examines the behaviour of firms considering how decisions of other
firms affect their own choices. For example, if a firm in oligopoly cuts price,
the outcome will largely depend on how other firms react, e.g. do other
firms also follow suit (starting price war), or do they keep prices high?
There are no guarantees in oligopoly.

The kinked demand curve model

One way of looking at oligopoly is through the kinked demand curve model,
though this makes various assumptions, which may not match reality.

• This model assumes firms seek to maximise profits.

• If a firm increases price, then they will lose a large share of the market,
because they become uncompetitive compared to other firms, and
therefore demand is elastic for price increases.
• If firms cut prices, then they would gain a big increase in market share.
However, it is unlikely that firms will allow this. Therefore, other firms
follow suit and cut prices as well. Therefore, demand is inelastic for a price
cut.
• This suggests that increasing or decreasing prices will lead to lower
revenue and therefore prices will be rigid in oligopoly.

28
Kinked demand curve model

This suggests that even variations in MC will not affect the price set.
Limitations of this model:
1. The model does not explain how prices were set in the first place.
2. Price stability may be due to other factors.
3. In the real world, firms often do cut or increase price.
4. Firms may not be profit maximisers, but seek increased market share, even
if it means less profit.

Non-price competition
If prices are rigid, and firms have little incentive to change prices, they will
concentrate on non-price competition. This occurs when firms seek to increase
revenue and sales by various methods, such as:
1. Advertising. This creates product differentiation and brand loyalty.
Advertising can also be used as a barrier to entry.
2. Product development. This could be an effort to improve the quality of
the product, such as mobile phones, with more features.
3. Loyalty cards. A reason for customers to come back.
4. Quality of service. Increasing loyalty and making demand more inelastic,
through better quality goods.
5. Location. Better location for firms. For many products, such as restaurants
and cafes, location is everything. Unless you have a good location, you will
not pick up passing trade.

29
Evaluate one pricing and one non-pricing method for firms to
increase profits

1. Non-pricing strategy - advertising

• The aim of advertising is to increase brand loyalty. If firms are successful,

then consumers will wish to buy the product, even at a higher price.
Successful advertising can make demand more inelastic, and therefore
increase profits.
• Successful advertising can also create a barrier to entry, because a new
firm may be unable to compete with an advertising budget of an
incumbent firm e.g. Cola market.
Evaluation

• It depends on the product. For example, advertising and brand loyalty

appear to be important for soft drinks and cars. However, it would be
relatively ineffective for a product like petrol, where people believe it is
homogenous and price will always remain the most important factor.
• It depends on the quality of advertising. Firms like Nike use top sports
stars to wear their products. This can make people wish to emulate their
heroes, but it can also backfire e.g. Nike’s long-term sponsorship of Lance
Armstrong may diminish people’s view of Nike.
2. Pricing strategy – Price cuts

• This involves undercutting rivals, through offering cheaper prices. If

demand is elastic and sensitive to price, this could lead to an increase in
sales and an increase in profits.
• This might work for a product like petrol and it worked reasonably well
with budget airlines, which were able to offer cheaper prices than
established national carriers.
Evaluation

• It depends how other firms react. If it starts a price war, with other firms
matching your price cut, it could lead to lower prices, as you have cheaper
prices but no increase in sales.
• It depends on the product. Supermarkets sell cheaper cola than Pepsi and
Coca Cola, but they are unable to take market share, because there is such
strong brand loyalty to the product.

30
Price wars
Firms may not seek to maximise profits but have other aims, such as increasing
market share and expanding the firm. This can explain why firms seek to reduce
prices and start price wars.

• Price wars are more likely in a recession, when demand is falling and
markets become more competitive.
• Price wars tend to be short-term because, otherwise, firms will make a
loss.
• Price wars are often selective e.g. supermarkets have selective price cuts
on “loss leaders”. This can give a misleading impression of price wars.
• A multinational will often subsidise a price war, by cross-subsidising the
price war from different markets in different countries.
• Price wars can be in the public interest, but only if firms don’t get forced
out of business by the low prices.

Predatory pricing
• This occurs when a firm lowers prices in some sections of the market,
with the intent of forcing another firm out of business.
• To set price below cost, the firm will need to cross subsidise the market
from other profitable markets. For example, a big multinational
corporation, like News International, could afford to run a price war in
British newspapers, by using profits from elsewhere.
• Predatory pricing is against the public interest, because the dominant
firm can increase prices when its rival has left. There is legislation which
makes predatory pricing illegal.

Limit pricing

• This occurs when a firm sets a price sufficiently low to deter entry. For
example, if a monopolist set a very high price, it would maximise their
profits but new firms may be encouraged to enter because of the level of
profit.
• Limit pricing would involve firms reducing prices, making less profit but
setting prices sufficiently low to deter new firms entering; this enables
them to maintain their monopoly position.

31
Collusive behaviour
• Collusion occurs when firms agree to limit competition, by setting output
quotas and fixing prices.
• A cartel is a formal collusive agreement. For example, OPEC is a cartel of
the major oil producers.
• Tacit collusion is an unwritten agreement where firms observe informal
rules, such as not undercutting rivals. Tacit collusion often occurs if there
is government regulation against cartels and collusion.
• Overt collusion is where firms are open about their deals to set prices and
output.
• Through collusion, firms are able to maximise profits of the industry.
There will be a similar price and outcome to a monopolistic industry, with
firms effectively sharing the supernormal profits.
• Collusion is seen as against the public interest, because of higher prices
leading to allocative inefficiency. There is legislation against collusion and
cartels in the UK.

The prisoner’s dilemma and game theory

• The prisoner’s dilemma is a situation where two agents may not co-
operate, despite co-operation being in their best interests. It is an example
of game theory application.
• A simple example in economics could be two firms (Sainsbury and Tesco)
who have a choice to set high or low prices.
• If both firms set high prices, they make high profit (£9m each)
• If they compete with each other and set low prices, they will make just
£3m each.

Tesco
Sainsbury High Price Low Price
High Price T=£9, S=£9 T =£13, S = £2
Low Price T=£2, S =£13 T = £3, S = £3

Breakdown of collusion
• However, when the market price is high, there is a temptation to cheat. If
Tesco cuts prices, whist Sainsbury has high prices, Tesco would make even
more profit (£13m) but Sainsbury would make less (£2m).
• Once a firm cuts prices, it encourages the other to cut prices and we end up
with low prices and low profit.

To keep prices high, there needs to be collusion, either overt or tacit. However,
this might be difficult, due to government regulation and other firms entering the
market.

32
Factors favouring collusion
1. A small number of firms who are well-known to each other with similar
costs.
2. A dominant firm who is able to have a lot of influence in setting the
price.
3. Barriers to entry; this is important to stop other firms entering to take
advantage of the high profits.
4. Effective communication and monitoring of output and costs, and
effective punishment strategies for firms who cheat.
5. No effective government legislation, e.g. collusion is illegal in the UK,
making it more difficult.

Evaluation of collusion
• Collusion enables higher profits. However, if firms are found guilty of
collusion, they can be fined and so end up with lower profits.
• Tacit collusion through dominant price leadership may be an effective way
to increase profits and avoid detection.
• However, this relies on other firms being willing to follow suit. This is
unlikely to occur if they aim at sales maximisation.
• Firms may justify collusion on the grounds that it encourages stability, and
the higher profits can be used to finance investment, leading to better
products.
• However, under collusions, firms may become inefficient, because it is easy
to make profit and they don’t have to try hard.

33
Monopoly
• A pure monopoly occurs when there is only one firm in the industry.
• In the UK, a firm is said to have monopoly power if it has more than 25% of
the market share.
• A monopoly will have barriers to entry.

• A monopolist maximises profit, where MR = MC.
• Therefore it sets price = P1 and quantity = Q1
• Firm makes supernormal profit = (AR- AC) × Q
• If the market was competitive, output would be Q2 and price P2 (normal
profit).

Disadvantages of monopoly
• Allocative inefficiency, because in monopoly, P > MC.
• Productive inefficient, because output is not at lowest point on AC curve.
• X-inefficient, because a monopolist has fewer incentives to cut costs;
therefore AC curve is higher than it could be.
• Less choice for consumers.
• Quality of product could be worse, because there are fewer incentives for
a monopolist to develop new products
• Monopsony power. A monopoly may also have monopsony power, in
employing workers and buying products. This means the firm can pay
workers lower wages, and supermarkets can pay farmers lower prices.

34
Advantages of monopolies
1. Economies of scale. If the industry has high fixed costs and economies of
scale, then a large monopolist can bring benefits of lower average costs,
which lead to lower prices for consumers.

Increasing output from Q1 to Q2 leads to lower average costs (P1 to P2).

• Economies of scale will occur most often in industries with high fixed
costs, or scope for specialisation. For example, airlines and car
companies tend to have high-fixed costs and therefore there tends to
be only a small number of large firms.
• Note: economies of scale may be so large that they outweigh everything
else, such as allocative and productive inefficiency.
2. Research and development. A monopolist can use its supernormal
profits, to invest in developing new products which may require high
investment. This is very important for industries, such as the
pharmaceutical industry where, without high profits, they would be unable
to develop new drugs.
3. International competition. A domestic monopoly may be necessary to
compete internationally. For example, Corus is the only steel producer in
the UK, but it faces competition from overseas competitors.
4. Monopolies may be efficient. A firm may gain monopoly power, because
it is efficient and innovative e.g. Google and Apple. A monopoly isn’t
necessarily inefficient ; the opposite may be true.

35
Examples of barriers to entry
1. High fixed costs. This enables the incumbent firm to benefit from
economies of scale. If a new firm entered the market, it would have higher
average costs and struggle to compete.
2. Vertical integration. This occurs when a firm has control over raw
materials and other supplies necessary for the good. For example, a new
airline may not be able to get landing slots at popular airports like
Heathrow.
3. Legal monopoly. For example, a patent on an invention.
4. Advertising. If a firm engages in advertising, then consumers may develop
very strong brand loyalty to a particular firm, making it difficult for others
to enter.
5. Being the first firm in the industry. For example, Microsoft was the first
firm and therefore people usually buy Microsoft Office to obtain
compatibility with everyone else.
6. Predatory pricing. If an incumbent firm cuts price when a new firm
enters the market, it may be able to force the new firm out of business and
retain its monopoly power.
7. Geographical barriers. Some monopolies are based on geographical
barriers, such as having access to diamond mines, or even local
monopolies, like motorway service stations.

Natural monopoly
A natural monopoly occurs when the most efficient number of firms in an
industry is one.
This will occur if there are very significant economies of scale in the industry.

• In this example, if the industry demand is 10,000 then, if one firm produces
10,000 units, it can have average costs of £15.
• If two firms were producing 5,000 each, the average cost would be double
(£30). Therefore, it makes sense for there to be just one firm.

36
Examples of natural monopoly
1. Electricity distribution. It makes sense to have only one firm distributing
electricity throughout the country. Once you have a network of electric
cables, there would be no sense in a second company having a rival
network of electric cables.
2. Train line. Usually, a train line between two cities would be a natural
monopoly. The fixed costs of building a line are so high; it makes no sense
to have competing lines. There would have to be very high demand to
justify a second line e.g. HS2 between London and Birmingham.

Monopsony
• This occurs where a firm has market power in employing workers, or
purchasing raw materials. The government is a monopsony employer of
fireman, as firemen don’t have many alternative employers.
• Often a firm with monopoly power in selling goods also has a degree of
monopsony power in buying raw materials.
• Supermarkets have sometimes been accused of using their monopsony
buying power to pay low prices to farmers who have no alternatives as to
where to sell their produce.

Disadvantages of monopsony power

• It means the firm has the market power to pay lower prices to suppliers
than in competitive markets. For example, suppliers to supermarkets such
as Tesco, have argued they set up production to meet Tesco contracts but,
after investment, they see prices squeezed, leading to lower profits for
suppliers.
• Monopsony is another way for monopolies to increase their profits,
increasing inequality in society.
• Lower wages. Workers facing a monopsony employer will face lower
wages and there will be fewer workers employed.
• Zero-hour contracts. Monopsonies are able to employ workers on
contracts which do not specific minimum hours worked; this can lead to
workers gaining little work and uncertainty over how much they will earn.

Advantages of monopsony power

• A monopsony buyer can counteract a monopoly. For example, a
monopsonist employer may be able to dilute the power of trades unions.
• Lower prices for consumers. By reducing prices paid to suppliers, firms
can help reduce prices that consumers pay.

37
Price discrimination
Price discrimination occurs when a firm charges a different price for the same
good to different groups of consumers.

• 1st Degree price discrimination - This is where the firm charges the
maximum price that a consumer is willing to pay. This is very difficult in
practice.
• 2nd Degree price discrimination -This is when consumers are charged
different prices according to how much they consume. For example, units
of electricity become cheaper after higher levels of consumption.
• 3rd Degree price discrimination - This is when consumers are grouped
into two or more independent markets. For example, train companies offer
discounts for people over 65 and to people travelling off-peak.
• Premium pricing – This involves charging a higher price for a better
quality good, e.g. a first-class ticket. It is not price discrimination, because
it is a different good, but the firm is trying to exploit different elasticities of
demand, similar to price discrimination.

Conditions necessary for price discrimination

1. The firm must be a price maker i.e. able to set prices. Price discrimination
can only occur in imperfect competition (oligopoly or monopoly).
2. The firm must be able to separate the market into different sections and
prevent resale, e.g. it must be impossible for an adult to use a child’s ticket.
3. There must be a different elasticity of demand for the different market
sections e.g. train firms can charge high prices at peak times because, in
this period, demand for train travel is inelastic.

Common examples of 3rd degree price discrimination

• Student discounts. Many shops offer 10% discount to students. This is
because students have limited income and are more likely to be sensitive
to price. It is relatively easy to separate the market e.g. check students
have a student card.
• Buy in advance. If you are able to buy train tickets in advance, you can
often have a big discount on original price. This is because people planning
ahead have more time to choose means of travel, and will be more
sensitive to price.
• Peak / off peak. If you buy train tickets at unpopular times of the day,
then you can get cheaper fares. Train firms charge higher prices at peak
time because demand is more price inelastic.

38
Diagram of price discrimination

How a firm uses price discrimination to increase profits.

• We assume marginal cost is the same for both groups.

• Market A has an inelastic demand; therefore, the price is higher, than
market B, where demand is more elastic.

Advantages of price discrimination

1. Firm will be able to increase revenue. This may enable some firms, who
may have otherwise have made a loss, to stay in business e.g. train
companies need price discrimination to offer off-peak travel.
2. Research & development. Increased revenue can be used for research
and development, which leads to better products for consumers.
3. Cheaper prices. Some consumers, often on lower incomes, will benefit
from lower fares e.g. pensioners can take advantage of cheaper fares on
trains.
4. Smooth demand. Price discrimination enables firms to sell surplus seats
(off peak) and reduce demand where there is over-crowding (peak).

Disadvantages of price discrimination

1. Higher prices. Some consumers will face higher prices, leading to
allocative inefficiency and a loss of consumer surplus.
2. Inequality. Often those who benefit from lower prices may not be the
poorest. For example, some old people may be quite rich, but the
unemployed will have to pay the full adult fare.
3. Administration costs involved in separating the markets and
implementing different prices.

39
Contestable markets
• A contestable market is a market where there is free and costless entry
and exit. This requires low sunk costs.
• Sunk costs are costs that cannot be recovered when leaving the market e.g.
expenditure on advertising is lost.
• In a contestable market, incumbent firms will always have the threat of
new firms entering the industry. Therefore, such a market will have a
competitive equilibrium, even if there are a small number of firms.
A perfectly contestable market has the following three features:

1. Absence of sunk costs

2. Perfect information
3. Freedom to advertise and a legal right to enter the market.

Hit and run competition

• If there are low entry and exit costs, then firms can engage in hit and run
tactics. This means that if an industry is making supernormal profits, then
a firm can enter and take advantage of high prices.
• If prices fall and the industry is no longer profitable, then the firm will
leave.
• Therefore, in a contestable market, a firm should be satisfied with normal
profits, otherwise it would encourage hit and run tactics from other firms.

Contestable markets and the public interest

Contestable markets can bring the benefits of competitive markets such as:

• Lower prices.
• Increased incentives for firms to cut costs.
• Increased incentives for firms to respond to consumer preference.
• However, there could also be significant economies of scale, because the
theory of contestable markets doesn’t require there to be many firms.

Implications of contestable markets

• Policy makers should not just look at the degree of concentration, but also
the degree of contestability and how easy it is to enter the market.
• Regulators in the privatised industries have often focused on removing
barriers to entry, rather than breaking up big firms. They hope removing
barriers to entry will increase the competitiveness of markets and lead to
lower prices.
• It can be important to allow firms to share a distribution network, which is
a natural monopoly e.g. consumers can buy gas from different companies
selling gas, whilst using the same national network of gas pipes.

40
3.5 Labour markets
Labour demand
• Labour is a derived demand. This means that demand for labour
depends on the demand for the goods they produce. If there is more
demand for going to restaurants, then there will be more demand for
catering staff.
• The demand for labour will be determined by the workers’ marginal
revenue product (MRP). This is the value that a worker can give a firm.
• Marginal revenue product (MRP) = MPP × MR. MRP is effectively the
increase in revenue a firm gains from employing an extra worker.
• Marginal physical product (MPP). This is the increase in output that an
extra worker produces.
• Marginal revenue (MR). This is the revenue that a firm gains from selling
the last unit of output. It is related to the price.

Firms demand for labour depends upon:

• Productivity (MPP) of workers – higher productivity = higher demand.
• Demand for the good. If there is high demand for watching footballers,
clubs will be willing to pay higher wages, because there is more money in
the sport. Footballers will have a high MRP.
• Substitutes to labour. In some production processes, firms could
substitute workers for machines (e.g. assembly lines).
• Wages. Higher wages cause a movement along the demand curve.
• Non-wage costs. This includes paying national insurance, health insurance,
and potential redundancy pay.

Elasticity of demand for labour

The elasticity of demand for labour measures how responsive demand for labour
is after a change in wages. Elasticity of demand for labour depends on:

• How essential is the worker? - Can labour be substituted for capital? For
example, with automated checkouts, workers can be substituted for
machines and labour demand will be more elastic.
• Number of people with qualifications and skills - If only a small number
of workers have qualifications, demand will be more inelastic.
• Time period - In the short term, demand for labour will be inelastic.
However, over time, it becomes easier to substitute labour for capital, so
demand becomes more elastic.
• Proportion of wage costs - If labour is a high % of total wage costs, the
firm will be more sensitive to a rise in wages.
Workers with inelastic demand are hard to replace. Therefore, they tend to have
greater bargaining strength and can demand higher wages.

41
Supply of labour
• Higher wages usually encourage a worker to supply more labour, because
work is more attractive compared to leisure.
• Substitution effect of a rise in wages. Workers will tend to substitute
income for leisure, because leisure now has a higher opportunity cost. This
effect leads to more hours being worked as wages rise.
• Income effect of a rise in wages. This effect involves workers working
fewer hours when wages increase. This is because workers can get a
higher target income by working fewer hours.

Backward bending
supply curve.

After a certain point,
higher wages may lead
to lower labour supply
because workers can
reach their target
income with fewer
hours.

Different workers will have different preferences. A worker with little expenses
may find the income effect soon dominates and higher wages encourage him to
work less and choose more leisure time.

Market supply of labour depends upon:

1. Wage rate. Higher wages cause a movement along the supply curve.
2. The number of qualified people and the difficulty of getting qualifications.
For example, if a job, such as lawyer requires lengthy and difficult
qualification process, supply will be inelastic.
3. The non-wage benefits (non-pecuniary) benefits of a job. This includes
status, job security, danger of job, how enjoyable the job is, the length of
holidays and other fringe benefits. The supply of tree surgeons will be
relatively lower because of the risk to health and safety.

42
Wage determination in competitive markets
• The equilibrium wage rate in the industry is set by the meeting point of the
industry supply and industry demand curves.

• In a competitive market, firms are wage takers because, if they set lower
wages, workers would not accept the wage.

• Therefore firms have to accept the equilibrium wage (We). If they tried to
pay a lower wage, workers would work for other firms who pay the
market wage.
• Because firms are wages takers, the supply curve is perfectly elastic,
therefore the wage = AC = MC
• The firm will maximise profits by employing at Q1, where MRP of Labour =
MC.

Assumptions of competitive labour markets

• Perfect information – about wages and available jobs.
• Freedom of entry and movement. In this theory, workers can easily move
between jobs.
• Many firms and workers. In this theory, workers have a wide choice of
employers to work for.

43
Example of wage differentials

Cleaner Accountant

In diagram on left (cleaner), elastic supply and demand lead to lower wages
In diagram on right (accountant), inelastic supply and demand lead to higher wages.

• Explaining low wages for cleaners

o Many people have sufficient qualifications to be a cleaner, therefore
supply is elastic.
o Due to the flexible nature of the work, it is job many people can do,
e.g women bringing up children. – increasing supply.
o Because the job is part-time and flexible hours, the fragmented
nature of the labour market means there is little trade union
representation .
o Demand is relatively elastic, because cleaners have a low MRP for a
firm - cleaners add relatively little profit to a firm.
o Therefore, equilibrium wages are relatively low.

• Explaining high wages for accountants

o The number of qualified accountants is limited, causing supply to be
inelastic. It is also difficult to gain sufficient qualifications as it takes
time to pass exams.
o Demand for accountant is likely to be high and inelastic, because a
successful accountant could make a big difference to the profit of a
company. Therefore, they have a relatively high MRP.

44
Market failure in labour markets
1. Monopsony
• This occurs when there is just one buyer of labour in a market, or if the
firm has substantial market power in employing workers.

• The marginal cost of employing one more worker will be higher than the
average cost. This is because, to employ one extra worker, the firm has to
increase the wages of all workers.
• Therefore, MC is steeper than AC
• To maximise the level of profit, the firm employs Q2 of workers where MC
= D (MRP).
• Therefore, in a monopsony, the firm only has to pay a wage of W2. This is
less than the competitive wage of W1.
• The monopsony also employs fewer workers than a competitive market.
• Lack of information, and difficulties in switching jobs, gives many firms a
degree of monopsony power.

2. Geographical immobilities
• Workers and firms can find it difficult to move, because of geographical
immobilities. For example, because of high living costs, it may be difficult
for workers to buy / rent a house in London. Therefore, there can be
labour shortages in London, but high unemployment in depressed areas.

45
Government policies to deal with geographical immobilities
1. Building new houses in popular areas. However, this is difficult to do,
because of limited space in places like the South East and London. It would
also require huge house-building programmes to bring prices down.
2. Subsidies to encourage firms to move to depressed areas. However,
firms may be reluctant to relocate to the north, even with subsidies,
because of limited infrastructure, which makes business harder.
3. Wage bonuses for expensive areas. The government could pay a wage
bonus for those living in London and other areas of high house prices.
However, this would become a very expensive way of dealing with the
problem.

3. Occupational immobilities – lack of skills

• Often, vacancies remain unfilled because unemployed workers have
inadequate skills to take on the jobs. This leads to occupational
immobilities and structural unemployment.
• The UK has many vacancies in jobs, such as HGV drivers. This is partly due
to UK not valuing practical vocational jobs as much as ‘academic
qualifications’.
• A shortage of skills may be more common in an economy facing rapid
technological and social change.

Government policies to deal with skills shortages

1. Government provision of education and training, with greater focus on
vocational skills needed by the economy. However, it is expensive and
there is a concern that people may not want to undertake government
training schemes, though the government could make training schemes a
requirement of receiving benefits.
2. Government subsidies to firms who provide training schemes. This
helps to overcome government failure, as the firm is likely to have better
knowledge of the skills that industry really needs. But the government still
needs to evaluate which ones would be good schemes to support.

4. Discrimination
• Firms may not be rational, but pay some workers different wages on the
grounds of age, race, or gender. Alternatively, firms may be unwilling to
employ people of certain sex or ethnic minorities.
Evaluation

• In theory, discrimination on the grounds of age, sex and race is illegal.

• In practice, it can be difficult to enforce discrimination legislation. For
example, it can be difficult to determine whether lack of promotion is due
to discrimination or other factors.

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Minimum Wage
With the decline of trade unions, the national minimum wage has become more
significant for dealing with issues of low pay.
From October 2015, the national minimum wage will be £6.70 an hour for
workers aged over 21.

• The rate for 18 to 20 year olds is £5.30 per hour

• The rate for 16 to 17 year olds is £3.87 per hour
• The apprentice rate is £3.30 per hour

Issues with minimum wage

1. Potential unemployment
A minimum wage above the equilibrium could cause unemployment of Q3-Q1.
This is because the minimum wage of W2 reduces demand for workers to Q1.
This is particularly a concern for some industries where wages are a high % of
costs. For example, hairdressers or service sector workers, such as cleaners.

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Minimum wage and monopsony
• A minimum wage could counter-act the effect of a monopsony employer,
an employer who pays lower wages and employs fewer workers.

• A monopsony is able to pay a wage of W2 and employ Q2.
• If the NMW increased wages to NMW 1, the demand for labour would stay
at Q2 and not cause any fall in employment.
• If the NMW was set at level W1, demand for labour would actually increase
to Q1.

Do firms in UK have monopsony power?

• Some jobs, like firemen, only have a government employer, so that is a
classic example of a monopsony.
• In theory, many service sector workers are free to choose employers but,
in practice, it is difficult to switch jobs. There are many costs and
uncertainties in applying for a job with higher pay.
• Many workers have little bargaining power and, if firms don’t increase
wages, they don’t have much alternative to switch elsewhere. Therefore,
arguably, many firms in the UK have a degree of monopsony power,
though it will depend on the industry and skillset of the workers.

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NMW and elasticity of demand and supply
If demand for labour is inelastic, a national minimum wage would cause little, if
any, fall in demand for labour. For example, if wages increase for the whole
service sector industry, they can pass the wage costs on to consumers.

• In this case, a NMW only causes a very small fall in demand for labour,
from Q1 to Q2.
2. Regional variations. A minimum wage may be insufficient to provide a living
wage in London because of higher living costs. But, in the north, employers may
not be able to afford it.
3. Impact on relative poverty. A minimum wage can increase the incomes of the
low paid and help reduce relative poverty.

• However, the minimum wage does not help the poorest e.g. those who are
out of work and living on benefits. Also, many who get a minimum wage
could be second income earners in a family.

Maximum wage

• A maximum wage could be implemented to prevent wages rising above a

certain level. For example, until 1961, there was a maximum wage for
English footballers of £20 a week!
• A maximum wage can help firms avoid spiralling wage costs, but also could
be used to increase firms’ profits. Maximum wages are very rarely used.

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Public sector employment
• In September 2013, there were 5.7 million people working in the public
sector across the UK, accounting for 18.8% of the workforce.
• This means that a significant share of the workforce have their pay set by
the government and not by market forces.
• There are public sector unions, such as UNISON, but often they have
limited bargaining power. Public sector jobs are not as critical as, for
example, coal mining was in the 1970s. If teachers go on strike, the
economy doesn’t grind to a halt, like when coal miners went on strike.
• Wages will be set depending on government finances and government
inquiries into suitable pay levels.
• To some extent, the government needs to compete with private sector
employment, e.g. attracting people into the civil service who might
otherwise go into the city. But, often, public sector pay has lagged behind
equivalent jobs in the private sector.
• Many public sector jobs have few alternatives. For example, the police,
doctors and fireman have few alternative career jobs, if not working for
the government. This gives the government more monopsony power in
setting wages.
• A concern is that the lack of profit incentive in the public sector means that
many jobs have little degree of performance-related pay. The government
has tried to introduce this in some areas but many jobs, like doctors and
teachers, make it hard to quantify effort and productivity.

Issues in UK labour markets

Some of the issues in UK labour markets include
1. More flexible labour markets.
2. Impact of net migration.

1. Flexible labour markets

A current issue in UK labour markets is the increased flexibility of labour markets.
Features of flexible labour markets include:

• Growth in part-time / temporary contracts.

• Growth in zero hour contracts. This means people are employed, but the
firm is under no guarantee to offer a fixed number of hours. This means
weekly wages can fluctuate significantly.
• Decline in trade unions and collective bargaining.
• Decline in jobs for life, increase in self-employment.

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Impact of flexible labour markets
• Unemployment fell quickly after the 2008 recession. Firms were more
willing to take on new workers.
• There has been a degree of under-employment, with people working fewer
hours than they would like in part-time work.
• Greater job insecurity. People have work, but there are fewer guarantees
the job will last. This greater job insecurity could have negative effects,
such as people becoming de-motivated because they have little attachment
to the firm. But it could also encourage workers to try harder to retain
their job.
• A flexible labour market could benefit workers who need to juggle looking
after children and working from home.
• A flexible labour market can benefit those who have the skills to gain an
income from new technology, such as the internet. However, a flexible
labour market could be damaging to unskilled workers, who find it hard to
get long-term job security.

2. Immigration

• Due to the expansion of the EU and the process of globalisation, many

foreign workers have been attracted into the UK. Immigration accounted
for 46% of net population growth in 2008.

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Impact of net migration into UK
• Increase in supply of labour. The increased supply of labour has often
filled gaps in jobs which firms have found difficult to fill e.g. cleaning and
fruit picking.
• Skilled labour. The government has set criteria, making it easier for
skilled labour to migrate. This has meant migration has played an
important role in filling vacancies such as nurses and doctors.
• Offset the impact of an ageing population. The UK has an ageing
population, which places greater strain on government finances (old pay,
less tax and need more pensions and healthcare spending). Net migration
of young workers helps the government’s budget situation, because they
are more likely to pay income tax and don’t receive pensions.
• Flexibility. In a period of high economic growth and job vacancies,
migrants will be more likely to be attracted to come and work. However in
a period of rising unemployment, migrants often return home. Thus,
migration can be a counter-cyclical factor in making UK labour markets
more flexible.
• Creating demand for labour. Migrants also add to overall aggregate
demand in the economy. With income earned, they will purchase goods
and services which indirectly creates other forms of employment in the
economy.

Problems of net migration

• Overcrowding. The UK experiences overcrowding, especially in parts like
the south-east. Migration and the rise in population places a greater strain
on the already limited housing stock and public amenities.
• Language barrier. It is sometimes argued that migrants have lower skills
than existing UK born workers, e.g. if English is not first language, it can be
harder to function in the labour market.
• Underground economy. Migrants are more likely to work in the black
market, avoiding regulations like minimum wages.
o However, there is a big difference between illegal immigration and
legal migration.
• Unemployment. Some people feel migrants take existing jobs.
Unemployment is high in UK; migration could make this problem worse.
o However, migration also creates jobs, through the additional
demand in the economy.

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3.6 Government intervention
• How governments intervene in markets to promote competition and
better standards.
• How effective this intervention is and the problem of government
intervention.

Competition Policy
Abuse of monopoly power is likely to be against public interest. Therefore,
governments are concerned to intervene and protect the interests of the
consumers. Anti-competitive practices which the government regulates include:

Collusive behaviour
• Price fixing - This occurs when competitors agree to increase prices
together.
• Vertical price fixing - These are arrangements when firms supplying goods
encourage the retailer to keep prices high.
• Collusive tendering - This is when firms agree to both put in high prices to
win a contract and prevent price competition, e.g. the concrete industry in
the 1980s was found guilty of collusive tendering.
• Agreements to limit output and split up the market.

Abuse of monopoly power

Chapter 2 of the 1998 Competition Act states it is illegal for a dominant firm to
abuse its monopoly power. Firstly, the Office of Fair Trading (OFT) must
investigate whether firms have a dominant position. They will look at:
• National or regional market share. Usually a firm would have to have at
least 40% of the market to be considered to be a dominant firm.
• The contestability of the market. If barriers to entry are low, then the
incumbent firm is unlikely to be dominant, even with a high market share,
because new firms can enter if profits are high.

If the firm is considered to be dominant, then the OFT will look at abuses of
monopoly power, which will include:
• Charging excessively high prices; if firms are making high profits, then this
is an indication of abusing monopoly power.
• Predatory pricing. This involves cutting prices and selling below average
cost, to force rivals out of business.

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 • Vertical restraints. This involves the monopoly firm imposing prices or
restrictions on its suppliers or retailers. For example, this could involve:
• Selective or exclusive distribution.
• Tie-in sales. For example, if you buy a printer, the company will try and
make you buy their own brand ink, which is more profitable than the
printer.

If firms are found guilty of abusing monopoly power, the OFT penalise firms:
• OFT can fine firms 10% of annual turnover.
• Make recommendations about the structure of the industry.

UK Merger Policy
Any potential merger must give details to the OFT. If the OFT is concerned, they
can refer the merger to the Competition Commission, which can examine whether
the merger is in the public interest.

Disadvantages of mergers
If a merger leads to a significant increase in market share, either in local or
national markets, the new firm could exercise monopoly power.
The legal definition of a monopoly is a firm with more than 25% of the market. If
the firm has monopoly power, there could be the following disadvantages:
1. Higher prices leading to allocative inefficiency and a reduction in
consumer surplus.
2. Monopolies are more likely to be productively inefficient.
3. If there is less competition, complacency amongst firms can lead to lower
quality of products and less investment in new products.
4. Fewer firms, therefore less choice for consumers.
5. With increased supernormal profits, the firm can engage in cross-
subsidisation or predatory pricing, increasing barriers to entry in the
industry.
6. The new firm can pay lower prices to suppliers (monopsony power).
7. Mergers can lead to job losses.
8. Motives for mergers may primarily be based on increasing prestige and
wages of workers concerned.
9. If the firm becomes too big, it may suffer from diseconomies of scale.

Potential benefits of mergers

1. Economies of scale. This occurs when a larger firm with increased output
can reduce average costs. This is important for industries with high fixed
costs.
2. Mergers can help firms compete on an international level.

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 3. Mergers may allow greater investment in R&D, because the new firm will
have more profit. This can lead to a better quality of goods for consumers.

Evaluation of mergers
The desirability of a merger will depend upon several factors, such as:

• Is there scope for economies of scale? What is the extent of fixed costs in
the industry?
• Will there be a significant reduction in competition?
• Is the market still contestable (is there freedom of entry and exit for other
firms)?
• The competition commission will look at each individual case and assess
its relative merits and demerits.

Regulation of monopolies
Governments can prevent mergers, but some firms are already monopolies, or
have significant monopoly power e.g. privatised monopolies, such as gas,
electricity and trains. In this case, there needs to be regulation of monopoly firms.
This includes:
1. Regulate prices - Prevent excessive price increases.
2. Profit regulation – Look at the profitability of firms. If it is excessive
compared to similar firms, it is a sign the firm is abusing monopoly
power.
3. Quality of service - Monitor performance targets and investment
levels.
4. Encourage competition – Remove barriers to entry.

Price-cap regulation
• Regulators have the power to limit price increases, or order firms to cut
prices by a certain amount.
• This is done through CPI – X (or RPI-X). This means that firms have to cut
prices by an amount x, after taking inflation into account.
• In certain industries, like water, regulators use CPI + K, where K is the
amount they can increase prices to fund necessary capital investment.

Advantages of RPI – X regulation

1. The system provides an incentive for firms to increase efficiency.
2. Different prices can be set, depending on the circumstance of the industry
and the system is therefore flexible.
3. The regulator should be independent of the government and the firm, and
can therefore act in the interests of the consumer.

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 4. If the information the regulator has is good, then they can increase
allocative efficiency by setting prices close to marginal cost.
5. Since the system started back in 1984, there have been significant cuts in
the real prices of telephones and electricity, suggesting it has been
successful.

Disadvantages of the RPI - X system

1. Regulators have often underestimated the potential cost savings of firms,
therefore x has been too low and regulation too soft. This has allowed
firms to increase their profits at the expense of consumers.
2. Regulators have been accused of regulatory capture. This occurs when
the firm persuades the regulator to look favourably upon the industry; if
the firm can control the information the firm receives, this is easier to do.
3. On the other hand, if regulators become too strict with the firm, it may
hamper investment. Firms may be reluctant to invest, if they fear the
regulator will make them cut prices.
4. It is possible that there may be fewer incentives to cut costs because, if
they do increase efficiency, the regulator may just increase the value of x.
5. Regulators need to look at more than just price. For example, they should
consider performance targets and quality of service.

Profit regulation
• Sometimes known as ‘yardstick competition’, this involves examining
levels of profit and seeing whether it is excessive. For example, in the late
1990s, the Labour government placed a ‘windfall tax’ of 23% on the profit
of privatised firms, who were considered to be making excess profits since
their privatisation.
• Many of these privatised firms had monopoly power and weak /
ineffective regulation.
• A windfall tax can be used to finance government spending in other areas.
• There have been calls to place a windfall tax on energy companies who
made high profits in the late 2000s, due to high energy prices.
Difficulties of profit regulation
1. Critics argue profit regulation is rather arbitrary and, as a consequence, it
is difficult to know how much to tax firms.
2. Windfall taxes and profit regulation may create a disincentive for a firm to
cut costs and become more profitable, because they will lose out to the
government in the future.
3. It is difficult to know whether high profit is due to a successful and
efficient firm, or the abuse of monopoly power.
4. Water companies have argued that they need substantial profit to finance
expensive, long-term investment. Windfall taxes could reduce long-term
investment and encourage a short-termism.

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Performance target / quality standards
• In addition to regulation of price and profit, government regulation needs
to make sure certain standards of service are maintained.
• Private firms may wish to cut costs, by lowering safety standards.
• Train companies are subject to close scrutiny, on issues such as
punctuality and safety records. Train companies who win franchises have
to maintain the level of service that they promised e.g. running off-peak
services.
Evaluation

• Government regulation on performance targets has been criticised as

being too weak. There is a lack of sanctions against firms who miss
performance targets.
• Performance targets can make companies alter behaviour just to meet
certain criteria e.g. train companies have changed timetables to give
themselves more time to arrive, making it less likely they will be late.
• Regulatory capture. Similar to price regulation, regulators may become
soft on the firms e.g. they rely on firms giving misleading information.

Policies to promote competition and contestability

1. Deregulation

• This involves removing legal barriers to entry e.g. Royal Mail used to have
a legal monopoly for delivering parcels and letters, but now firms can
enter the market.
• It has been effective for increasing competition in the retail of electricity
and gas to consumers. With increased competition, there is no need for
price regulation.
• Deregulation cannot create competition in a natural monopoly, such as
electricity networks and train companies.

2. Promoting small business

• Governments can offer tax breaks and subsidies to help small firms
develop, creating more competition.

However:

• For many monopoly markets, small firms will not be able to benefit from
the economies of scale and so it is ineffective.
• Also, government tax breaks and subsidies may be insufficient to help
small firms. It depends on the quality and success of the business, much
more than government help.
• Governments are also likely to suffer from poor information (asymmetric
information) about how to help small firms. This is an example of
government failure.

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Competitive tendering
This occurs when local councils / government allow firms to bid for the right to
run certain services, such as refuse collection and providing school meals.

• The idea is that the firm which offers the best bid will win the rights to run
the service for a certain period of time. Competitive tendering may involve
the existing council or new private firms.
• It is a way to ensure a degree of competition, at least in the bidding process.
It encourages firms to develop efficient methods of operation, to make sure
they can win contracts.

However, problems of competitive tendering include:

• It gives firms a private monopoly for the length of the contract and there is
a danger the private firm will increase prices, or cut back on service.
• It requires the government to monitor the quality of service provided and
to make sure they don’t take shortcuts to boost profit.
• Because the contract is short-term, it may discourage long-term
investment.
• Costs involved in the bidding process.

Other methods to increase competition

• Force firms to allow competitors to use its network. For example,

electricity generation is a natural monopoly, but the government can allow
individual firms access to the network, to sell electricity to customers.
• Legislation against predatory pricing (selling below cost to force rival
firms out).
• Subsidies to new firms to enter a monopoly market. For example, subsidies
to renewable energy firms trying to provide alternatives to existing power
firms.

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Privatisation
• Privatisation involves selling state-owned assets to the private sector.
• The UK has privatised many state owned assets, such as BT, BP, British Gas,
electricity and Royal Mail.
• Privatisation is often accompanied by deregulation, which involves
reducing legal barriers to entry and opening up the market to more
competition.

Benefits of privatisation
1. Reduced government interference. State-owned industries may be
managed for political reasons e.g. there could be under investment,
because governments take the short term view.
2. Removing borrowing limits. State-owned companies are subject to strict
spending limits. Private companies are free to borrow and invest in new
lines e.g. Chiltern Railways have invested in new lines and stock.
3. Private companies are usually more efficient. This is because, when
working in the public sector, there is often little incentive to cut costs and
increase profits. However, private firms will have this profit incentive,
therefore they are more likely to develop new and better products.
4. Improved public finances. Receipts from privatisation could help reduce
government borrowing. However, this is a one-off income and the
government will lose future profit revenues from losing ownership of the
companies.
5. Increased competition. The main benefits from privatisation occur when
there is successful deregulation and an increase in competition. This will
lead to the usual benefits of competitive markets:
• A lower price leading to greater allocative efficiency (P=MC).
• Better quality of consumer service, as firms compete for market share.
• Firms must be more efficient, in order to remain profitable.

Potential problems of privatisation

1. Barriers to entry. If there are significant barriers to entry, such as high
fixed costs, it may prove difficult to increase competition. Industries like
water and railways can be seen as a natural monopoly. Therefore,
privatisation could create a single private monopolist and not actually
increase competition.
2. Public services should be run in the public interest. Many industries
which were privatised are important public services, such as railways and
gas. Therefore, it may not be appropriate to apply profit-maximising
principles in these industries.
3. Positive externalities. Industries such as railways have positive
externalities, such as reduced pollution and congestion. Therefore, in a free
market, they will be under-consumed. If the government manages these
industries, it can make sure they overcome market failure and take
external benefits into account.

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Public private partnerships (PPP)
A public private partnership (PPP) or a private finance initiative (PFI) occurs
when the government seeks to involve a private firm in a public investment
programme. This could involve building a new motorway (e.g. M4 relief road)
with public and private money.

Advantages of PPP
1. Private firms will pay part of the cost, therefore saving the government
money.
2. Private firm involvement will help ensure public money is used for
worthwhile projects and avoid 'white elephants', public schemes not
required by the market.
3. Private firms will encourage greater efficiency in use of resources, because
they have a profit incentive.
4. Government subsidy ensures that the external benefits of the scheme (e.g.
better environment / less congestion) are taken into consideration.

Disadvantages of PPP
1. Government invests substantial funds, but the private firms reap the
benefit in terms of higher profit.
2. Private firms will cherry-pick the most profitable schemes and not help on
necessary, but unprofitable, schemes.
3. Private firms may run the scheme, to maximise profit-leading to a poorer
range of services and higher prices for consumer.

Contracting out
This is when public services are given to private firms. The idea is that private
firms will be more efficient than local councils in providing services, because of
the profit motive. Private firms have to bid for the right to run the public service.

Case Study Rail Privatisation

With rail privatisation in 1993, British Rail split up into:
1. Railtrack – responsible for track and infrastructure.
2. Regulator - Office of the Rail Regulator (ORR) - responsible for managing
and regulating franchises, as well as setting standards of service. In 2005,
gained responsibility for safety, too.
3. Train operating companies and freight train operators.
4. Franchises process. Companies were invited to bid for the right to run
train services for certain time periods.

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Impact of privatisation
• Railtrack went bankrupt and was replaced by Network Rail, a
private limited company, whose borrowing is guaranteed by the
government, a partial renationalisation.
• Number of train companies reduced.
• Some private train companies got into financial difficulty and the
government had to bail out services, such as the East Coast main
line.
• Prices. Twenty years after privatisation, some prices (e.g. single
standard tickets) have increased by up to 208%, whereas season
ticket price rises hover just below, or slightly above, the rate of
inflation, with an increase of between 55% and 80%.
• A boom in rail journeys. Rail travel has increased 84% and the
number of passenger-km by 88%. However, it is difficult to know
whether this is due to privatisation, or other factors (e.g. rising
petrol prices, congestion and economic growth).
• Despite the Hatfield crash, the safety record of British railways is
one of best in Europe.
• Number of train companies less than expected, with many
companies owned, or part-owned, by foreign state companies e.g.
Deutsche Bahn and SNCF.
• Government subsidy to railways has doubled during privatisation
to £4 billion.
• The privatisation of rail still requires substantial government
regulation and government money.
• The franchise system which separates infrastructure and train
companies has been criticised, as there is confusion about who is
responsible, with complex systems of compensation when trains
are delayed, depending on whose fault it is.

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