EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 3 Business growth

Types of firm Small firms

Firm: business enterprise that produces and sells goods/services; it turns • Most businesses in the UK are small or medium-sized enterprises (SMEs)
factor inputs into output • Developments in e-commerce has enabled the creation of more small
For profit organisation: a firm that aims to make profit businesses, with a relatively small online presence
Not-for-profit organisation: firm that operate commercially but aims to
improve social welfare & environmental goals; profits are reinvested for Why some firms stay small
social purposes • Selling to a niche (very small, specialist) market (low PED or high YED
Private sector business: firms owned by private investors rather than the for goods)
state • May act as a supplier/subcontractor to larger businesses; produces a
Public sector business: organisation owned and controlled by the state, specific component in the overall production line
e.g. the NHS, the Police, the Armed Forces • Focus on good customer service/product
differentiation/USP/quality/more personalised service/better
Separation of ownership from control of firm
communication with customers
The nature of the ownership of firms changes as firms grow: • Enables more flexible response to changing market demand; allows
Sole Trader: A business owned and operated by an individual who retains all profits.
Partnership: A business structure where two or more individuals own and manage more innovation
the business together, sharing the profits. Commonly found in professional services • Lack of resources/access to finance for expansion
such as lawyers and doctors. • Low minimum efficient scale (link to economies of scale)
Private Limited Company: A type of company whose shares are not publicly traded • Lack of motivation/'easy life' option/ keep as a family business
on a stock exchange. The ownership is limited to a specific number of shareholders, • To avoid higher business taxes
and shares are not available for public purchase.
• Allows access to informal/local labour markets
Public Limited Company: A company whose shares are listed on a public stock
exchange, allowing them to be bought and sold by the general public. Shareholders • Operating within a competitive market structure i.e. monopolistic
have voting rights, typically exercised at the Annual General Meeting (AGM), but they competition
are not directly involved in day-to-day business operations. • May still benefit from external economies of scale
There may be a principal-agent problem when the shareholders (the • Avoids scrutiny from competition authorities e.g. the CMA
principals) have different objectives from the managers (the agents). This • May avoid being taken over
is a form of information failure • Avoids internal diseconomies of scale
• Shareholder aim: to earn profit from dividends and increase their
shareholder value (capital gain) Why some firms grow
• Managers consider their own careers/job satisfaction; they may Successful businesses typically grow because there is an increase in the market
sacrifice short term profit from long term profit; profit-satisficing demand for the product they are selling
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 3 Business growth
Types of business growth Advantages of growth of firms
Internal growth: also called organic growth – when a firm invests in new • Increased control of markets/resources
capacity to increase the business size • Increase control of sales/customer base
External growth: business grows by acquiring another business via • Gain internal economies of scale
merger or takeover • Helps ensure business survival/takeover competitors
Horizontal integration: a merger between two firms in the same industry • For managerial reward
at the same stage of production • Helps gain expertise
Vertical integration: a merger between two firms at different stages of • Increased productive and dynamic efficiency
production in the same industry • Synergy
Backwards vertical integration: business buys one of its suppliers e.g. car • Spreads risk; allows diversification
maker buys up a tyre company
Forwards vertical integration: business supplying a good merges with Why some mergers & takeovers fail
one of its buyers, e.g. car maker buys up a car dealership • High financial costs of during a takeover can leave a debt overhang
Conglomerate merger: merger between two firms producing unrelated • Integrating different technology systems can be expensive/near
products impossible
Lateral integration: merger between two firms in industries that are • Share price may fall if fresh equity needs to be raised via a rights issue
somewhat related e.g. software company buying a games designer • Clash of corporate cultures/personalities
Friendly takeover: Board of Directors of the target company recommend • Loss of customers/poorer customer service
shareholders accept takeover bid • Possible loss of skilled workers
Hostile takeover: Board of Directors of target company recommend • Businesses in competition to buy out a business may end up paying too
shareholders reject the bid; predator company has to buy 50% of shares much
in target company to take control • Bad/unlucky timing if the economic cycle changes course

Key constraints on business growth Why some firms de-merge

Market size: a firm will not grow if the demand is not there Demerger: when a firm splits into separate firms
Access to finance: a growing firm may need enough retained profit or a • To focus on its core business/core product
business loan to expand; the cost of finance may also affect its decision to • To provide better quality service
grow • To become more specialised
The objectives of the business owners: may not be profit-maximisers • To reduce the risk of diseconomies of scale
Regulation: large firms may gain monopoly power which could be • To raise money from the asset sale
investigated by the competition authorities • To avoid the attention of the competition authorities
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 3 Business objectives & revenue
Types of business objectives AR, MR and TR, for price-makers & price-takers
Profit-maximisation: firm aim to make the maximum profit possible (occurs Total revenue: quantity sold x price; TR = Q x P
where MC = MR; this is also the loss-minimising condition) Average revenue: revenue per unit sold; AR = TR/Q
Revenue maximisation: firm aims to maximise total revenue (occurs where Marginal revenue: the change in TR when one more unit is sold; MR = change
MR = 0) in TR/change in Q
Sales (volume) maximisation: firm aims to have largest market share without Price-maker: a firm with some market power that can alter prices
running at a loss (occurs where AC = AR) Price-taker: a firm with no market power, selling at the market price only
Profit satisficing: managers aim to make enough profit to satisfy the
shareholders

Diagram showing different business objectives

Profit-maximisation occurs at
output Q1, where MC=MR
Revenue maximisation occurs
at Q2, where MR=0
Sales maximisation occurs are
Q3, where AC=AR

Profit satisficing
Managers can choose any
output between Q1 and Q2,
depending on their objectives,
For price makers: Marginal Revenue For price makers: Marginal Revenue
because between these (MR) is less than Average Revenue (MR) is equal to Average Revenue (AR),
output levels, there is enough (AR), because to sell additional units, because every unit is sold at exactly
profit to satisfy the the price of all units needs to be the same price. TR is upwards sloping
shareholders. lowered. TR is max when MR = 0 with constant gradient
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 3 Short run costs
Short Run Costs Marginal costs
Fixed costs: costs that do not vary with output; the total costs incurred Marginal cost MC is the
when output is zero change in total costs when
Variable costs: costs that vary directly with output output increases by one
Short-run: the period of time in which at least one factor of production is unit.
fixed MC = change in total
Long-run: the period of time in which all factors of production are variable costs/change in output
Total costs in the short run • Marginal costs are
variable costs; MC is the
Total fixed costs TFC do not gradient of the TC
change with output
Total variable costs TVC increase The relationship between AC and MC
as output rises, but the Short-run explanation: LAW OF
relationship is not linear because DIMINISHING RETURNS as extra
of the Law of Diminishing Returns variable factors are added to fixed
factors, the fixed factors e.g.
Total costs TC = TFC + TVC capital become increasingly scarce
and marginal product falls (from
Q), causing marginal cost to rise
Average costs in the short run
MC always cuts AVC and AC
Average fixed costs AFC = TFC/Q; curves at their minimum
AFC decreases with output point.
Average variable costs AVC ; the • If you add more to the
curve is U-shaped, at lower outputs total than the current
output rises faster than TVC; at average, the average
higher outputs, TVC rise faster than rises; if you add less to
output your total than the
Average total costs ATC = AFC + AVC current average, the
average falls
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 3 Long Run Costs & Economies and Diseconomies of Scale
Economies of scale Long run average cost (LRAC) curve
In the long run, all factors of production are variable, so a firm can 'scale up'. LRAC curve is drawn assuming there
There can be cost advantages when operating at a larger scale known as is an infinite number of plant sizes that a
economies of scale or increasing returns to scale; EoS = falling long run business can use:
average costs (LRAC) • If LRAC is falling when output is
increasing, then the firm is
Internal v external economies of scale experiencing economies of scale.
Internal economies of scale arise because of the growth in output of the • Conversely, when LRAC eventually
firm itself as it expands its own operations; efficiencies in production are starts to rise then the firm experiences
gained reducing LRAC. diseconomies of scale
• If LRAC is constant, the firm is
External economies of scale arise from factors outside the firm because of experiencing constant returns to scale
the growth in the size of the industry or the business environment in which
the firm operates, reducing LRAC for individual firms. External economies of scale; shift down in LRAC
Internal Economies of Scale
External EoS cause the firm's
Technical EoS = use of specialised equipment, automated manufacturing; law of
increased dimensions e.g. containerisation,
LRAC to shift down – lower
Purchasing EoS = lower price per unit from bulk buying, larger firm can use its average costs at every output
monopsony power level.
Managerial EoS = using specialist staff, a form of the division of labour, e.g. specialist External diseconomies of scale
production manager would shift it up
Financial EoS = bigger firms are often less risky and can get bigger loans at lower
interest rates than smaller firms
Risk-bearing EoS = larger firms can diversify to spread risk; makes business more Minimum efficient scale MES)
resilient to changes in market conditions
MES: the lowest output Q1 where the
External Economies of Scale firm is at the lowest point on the LRAC
Sometimes called agglomeration economies or clustering
Infrastructure: industries cluster geographically to benefit from shared infrastructure, The business achieves productive
e.g. Media City in Salford; fishing industry in Grimsby efficiency.
Knowledge & labour pool: in some regions there may be a strong knowledge sharing If the MES is low relative to total market
environment e.g. City of London, Cambridge Uni & Science Park output, then it is likely there will be a
Supplier networks: clusters of related businesses can lead to a strong supplier large number of small firms in the
network e.g. specialised components in automotive industry
industry and vice versa
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 3 Profits & Shut Down Points
Profit (TR-TC = profit) Shut down points
Profit = total revenue (TR) - total costs (TC) If a firm is making losses it may decide to shut down. In the short run, it is
Normal profit: the profit that the firm could make by using its resources in assumed it will still have to pay its fixed costs.
their next best use; it is the profit needed to keep the firm in business; it is The firm will shut down in the short run if:
effectively a cost of production. Normal profit is earned when TR=TC Price per unit (AR) < average variable cost (AVC) or when total revenue (TR)
Supernormal profit: also called abnormal profit is any profit over and above < total variable cost (TVC)
normal profit In the long run, all costs are variable, so the firm will shut down in the long
Profit run if:
Price per unit (AR) < average total cost (ATC) or when total revenue (TR) <
Supernormal profit exists total cost (TC)
when TR>TC; it is maximised
when the vertical difference Diagrams showing short run shut down points
between TR and TC is For a price taker For a price maker
greatest

Profit maximisation MC=MR

Up to output Q, MR>MC so for each
extra unit produced more is added to
revenue (MR) than is added to costs
(MC) so profit rises.
Beyond output Q, MR<MC so for
each extra unit produced less is added In both cases, the firm is minimising its losses by producing where MC=MR.
to revenue (MR) than is added to Losses are area ABCP. Point A is the shut down point (where AVC = AR)
costs (MC) so profit falls If there was any increase in variable costs and/or decrease in revenue, then the firm
would shut down
A common simplifying assumption is that a firm will aim to maximise In the long run, there is no distinction between variable and fixed costs because all
its profits. (This assumption can be broken down in evaluation). costs are variable; the diagrams would be the same, but without the ATC curves
Profit-maximisation occurs at the out where MC=MR. drawn on AND the AVC curves would be labelled ATC
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 3 Efficiency
Economic efficiency X-inefficiency
Efficiency is about a society making optimal (best) use of our scarce X-inefficiency: when a firm is not operating at its optimal level of efficiency
resources to help satisfy changing wants & needs. due to internal factors such as poor management, lack of motivation, and
Allocative efficiency bureaucratic inefficiencies.
Allocative efficiency: when no one can be made better off without making Diagrams showing productive efficiency and X-inefficiency
someone else worse off. Also known as Pareto efficiency/optimality
• Allocative efficiency occurs when the value that consumers place on a product Productive efficiency is achieved at
(reflected in the price they are willing and able to pay) equals the marginal cost of output Q because the firm is operating
factor resources used up in production.
at its minimum LRAC (at A or cost per
Condition required for allocative efficiency in a market is that price = unit C1)
marginal cost of supply (P = MC); on a diagram this is where AR = MC If the firm faced average costs at C2
Allocative efficiency in a competitive market when its output was Q, it would be X-
Up to output Q, the price consumers are inefficient
willing to pay (shown by the demand
curve) is higher than the cost of the Dynamic efficiency
scarce resources used to produce the Dynamic efficiency: achieving efficiency over time; it refers to ongoing
good (shown by the supply curve), so it is innovation of products and production techniques and is all about long-
efficient to allocate scarce resources to term growth and development.
produce these units Product innovation: when companies invest in R&D and introduce new products or
services to increase their competitive advantage, reduce costs, and improve the quality
For output units beyond Q this is no
of their offerings.
longer the case. Process innovation: the improvement of existing processes or the development of new
In a competitive market, social welfare (consumer surplus + producer ones to increase efficiency and productivity e.g. automation
surplus) is maximised at when the equilibrium quantity is produced Creative destruction: Schumpeter's concept that states that innovation and
technological change lead to the replacement of old technologies and products with
Productive efficiency new ones, leading to economic growth and progress.
Productive efficiency: when a firm is producing goods or services at the Static v Dynamic efficiency
lowest possible average cost, using the fewest possible resources. Static efficiency: the optimal allocation of resources at a specific point in time; optimising
• Firm produces the maximum output with the given inputs, without any waste or
existing resources and processes, focused on efficiency and cost reductions
inefficiencies.
Dynamic efficiency: efficiency over time i.e. the long-term allocation of resources and the
Productive efficiency is achieved at an output that minimises the unit cost potential for continuous improvement and adapting to changing conditions; emphasis is
(AC) of production on innovation, adaptability, and continuous improvement.
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 3 Perfect competition
Characteristics of perfect competition Perfect competition in the long run
• Large number of buyers and sellers (firms)
• Homogenous (identical) products
• Perfect information
• No barriers to entry or exit
• Firms are price takers - they cannot influence the market price; demand
to the firm is perfectly elastic (horizontal) and P=AR=MR
• Supernormal profit is competed away in the long run
Perfect competition in the short run

In the long run, because there are no barriers to entry, new firms will join
the market to gain some of the supernormal profit. This causes the market
supply curve to shift right and the market price falls to P2. The firm now
has to take the new lower price P2: the profit-maximising output falls to
Q2, where the firm is making normal profit only.
All supernormal profit is competed away by the entrance of the new firms.
If the firm had been making losses in the short run, some firms would leave the
market & market supply shifts left; the market price would rise until the long run
equilibrium is restored.
In perfect competition, the firm 'takes' the market price P. Assuming
profit-maximisation, the firm will produce the output Q where MC=MR. Perfect competition & efficiency
At Q, AR is greater than AC, so profit per unit is AB. Total supernormal Allocative efficiency (P=MC): firms are allocatively efficient in both the short and
profit is the shaded area ABCP. long run; as a price taker P=MR so when MC=MR, P=MC
Productive efficiency (min LRAC): in the long run, the firm will produce where the
Minimum losses in the short run long run AC curve is at its minimum, so firms are productively efficient
If the firm faced higher costs, so AC>AR at the output where MC=MR, then Dynamic efficiency; we assume firms make homogenous goods so there is little
the firm is making losses. scope for innovation and differentiated to try to establish some market power.
• The firm will shut down if its revenue does not cover its variable costs (if However, it is worth noting that in the real world, firms in competitive markets
AR< AVC) in the short run. often are very entrepreneurial and innovative, but these markets may not fully
• The firm will stay open in the short run if AR>AVC meet the theoretical criteria for perfect competition
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 3 Monopoly
Characteristics of monopoly Monopoly in the long run
• Single seller In the long run, because there are high barriers to entry, no new firms can
• Unique products (with no/few substitutes) join the market so the monopolist can earn the supernormal profits in the
• High barriers to entry long run.
• Firms are price makers - they can set the market price though are The diagram for the long run is the same as for the short run.
constrained by demand – a higher price means a lower quantity If the firm had been making losses in the short run, it would have to shut down in
demanded. Demand slopes downwards to the right D = AR , but MR is the long run unless demand increases (boosting revenue) or the firm is able to cut
twice as steep because to sell more the firm has to reduce the price its costs.
• Supernormal profit can be earned in the long because barriers to entry Monopoly v monopoly power
are high In theory, there is one supplier in a monopoly, but a firm that has more than
Monopoly in the short run 25% of a market can wield monopoly power
Natural Monopoly
Assuming profit- Natural monopoly: a single firm can efficiently serve the entire market due
maximisation, the firm to significant economies of scale e.g. utilities, transportation networks
will produce the output • High fixed costs relative to variable costs and declining average costs
Q where MC=MR. It can • High minimum efficient scale
charge price P according Natural monopolies can benefit consumers by providing services at lower
to the demand curve. At costs than multiple competing firms would achieve, but they require
Q, AR is greater than AC, regulation to prevent potential abuse of market power.
so profit per unit is AB. Monopoly and efficiency
Total supernormal profit
Allocative efficiency (P=MC): a monopoly is NOT allocatively efficient in
is the shaded area ABCP
either the short nor long run; P>MC.
Productive efficiency (min LRAC): the monopoly is NOT productively
Minimum losses in the short run efficient – it produces to the left of the minimum AC
If the monopolist faced higher costs, so AC>AR at the output where MC=MR, Dynamic efficiency; the monopoly has supernormal profits it can reinvest in
then the firm is making losses. the business – it can use the profits for R&D and product and process
• The firm will shut down if its revenue does not cover its variable costs (if innovation. The monopoly can therefore be dynamically efficient.
AR< AVC) in the short run. A monopoly that does not innovate may lose its market dominance and the
• The firm will stay open in the short run if AR>AVC barriers to entry in the market may weaken
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 3 Barriers to entry & monopsony
Barriers to entry Barriers to exit
Barriers to entry: factors that make it difficult or impossible for firms to Barriers to exit: Make if difficult or impossible for firms to cease production
enter an industry and compete with existing firms. and leave an industry
Natural barriers: the nature of the industry makes it efficient for one or a Examples include: asset write-offs, closure costs and lost reputation
small number of large firms to operate in the industry If barriers to exit are high, this can act as a deterrent to enter an industry i.e.
Legal barriers: laws and regulations make it difficult for firms to join the the barrier to exit = a barrier to entry
industry. Monopsony
Strategic/artificial barriers: barriers put in place by firms already in the Monopsony: a single buyer
industry to prevent an increase in competition. These can be anti- Buying power: a firm or group of firms have a dominant position as the buyer
competitive and may be illegal. of a product/service
Barriers to entry are important because they help determine how Firms can use their buying power to get better prices from their suppliers,
competitive a market is likely to be. The higher the barriers to entry, the helping to reduce costs
more likely there will be less competition and more market concentration Benefits of monopsony power
• Firms can gain purchasing economies of scale reducing long run average
Types of barriers to entry costs
Natural barriers include: high capital start-up costs or high sunk costs; high • Lower costs help increase supernormal profits
economies of scale (as for natural monopoly); geographical barriers • Better returns to shareholders
Legal barriers include: patents, copyrights & trademarks; licencing; public • Extra profit may be re-invested to improve dynamic efficiency
franchises; import controls • Consumers may gain from lower prices (as costs are lower); increase in
Strategic barriers include: ownership or control of the factors of production the consumer surplus
needed (via vertical integration); control of the technology needed; limit • Better value for money, e.g. NHS can buy drugs more cheaply and give
pricing, predatory pricing; marketing barriers e.g. brand more treatments
proliferation; advertising barriers that create brand loyalty; other anti- Problems with monopsony power
competitive practices
• Business use their buying power to squeeze lower prices from suppliers
Limit pricing & predatory pricing
• Some suppliers may have to leave that industry if they make losses,
Limit pricing: the monopolist cuts its price and increases output so it is
causing job loss; future supply chains may be less reliable
making normal profit only (AC=AR = P), then a new firm with potentially
• If supplying firms leave, consumers may end up with less choice and/or
higher AC will not be able to compete.
higher prices
Predatory pricing: the monopolist cuts its price and increases output so it is
• Monopsony employers can use their labour market power to depress
running at a loss; a new firm with potentially higher AC will not be able to
wages and negatively affect the real incomes of their workers
compete. Once the threat of competition is gone, it puts its prices up again.
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 3 Monopoly v Competition
Monopoly v competitive market Disadvantages of monopoly

Higher prices: prices are higher in monopoly than under competition

The monopoly produces where Loss of allocative efficiency (P > MC); net welfare loss compared to
MC=MR; its chooses output competition
Qm and charges price Pm. Inequality: may worsen because higher prices may affect those on lower-
If the market was competitive, incomes harder (regressive)
the equilibrium is where D = Sc X-=inefficiencies: e.g. wasteful marketing spending because of the
at price Pc and quantity Qc. absence of market competition
To maximise its profits the Diseconomies of scale: may cause a loss of productive efficiency in the
monopoly restricts output and long run
raises its price. Lack of choice for consumers: lower consumer welfare
Monopsony power: firms with market power can often use this to apply
pressure on their suppliers to reduce prices
This creates a net welfare loss of ABE because the monopoly is not
Supernormal profit: this may not be reinvested in the business but
allocatively efficient. The units of output between Qm and Qc are all
distributed to shareholders and/or used to increase CEO/manager pay
valued more highly by consumers than the marginal cost of producing
them. Advantages of monopoly
Monopoly costs v costs in competition Supernormal profit: can be used to fund extra capital investment &
In the analysis above, there is a big underlying assumption that MCm = Sc research projects that spark innovation; dynamic efficiency.
i.e. that the cost structure faced by the monopoly is the same as the Economies of scale: monopoly may have much lower costs than if
collective one for all the firms when the industry is competitive. industry was made up of smaller firms; this is especially the case for a
This may not be the case if the monopoly can gain economies of scale. natural monopoly.
If Sc lies to the left of MCm due to higher costs because of smaller scale Increase international competitiveness: a domestic monopoly with
production by the competing firms, the monopoly price could be lower and economies of scale can compete more successfully on price and cost in
its output higher than under perfect competition. international markets.
For a natural monopoly, the most productively efficient scale is the largest; Regulation: laws and industry regulators can ensure monopolies do not
it makes sense to gain the economies of scale, but the monopoly may need exploit consumers with excessive prices and that they maintain quality
regulation or be nationalised to prevent profiteering from high pricing Enables price discrimination: can help some lower-income families.
strategies. Indeed, some services might be provided free to consumers.
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 3 Price discrimination
Price discrimination Benefits of price discrimination
Price discrimination is charging different prices to different groups of consumers • Firm makes greater supernormal profits
for an identical good or service for reasons other than differences in cost. • Firm extracts some of the consumer surplus to add to its profits
Price discrimination is possible when • Profits could be used to re-invest in the firm and increase
• there are high barriers to entry & firms have some monopoly power dynamic efficiency; firm may use profit for R&D and innovation
• the market can be split into two or more distinct groups of consumers, which • Firm may use profit to improve the quality of its good/service
have different PEDs • Firm may use extra profit to cross-subsidise loss-making services;
• there is no market seepage (consumers cannot buy in one sub-market and extra profit could turn a loss-making firm into a profit maker
sell in another); the cost of keeping the markets separate should be low ensuring the good/service continues to be supplied
• Some consumers in the 'elastic demand' sub-market may be able
Price discrimination diagram to afford the good at the lower price Pb
• Firm's market is greater as it absorbs some lower-income
consumers
• It can help firm's use spare capacity (price can be lower at times
when there is high capacity and high when there is no spare
capacity)
• May enable a firm to break into a new market at home or
abroad and make it more competitive
Costs of price discrimination
• Consumers in the 'inelastic demand' sub-market pay a higher price
• There is a loss of consumer welfare (the firm extracts some of the
The price discriminating firm 's costs are determined in the whole market consumer surplus); i.e. consumer exploitation
MC and AC are set at this level in each sub-market • Price discrimination may also firms to use predatory pricing tactics
Inelastic demand: the firm sets MC=MRa, it chooses output Qa and can • Can reinforce monopoly power
charge price Pa in this sub-market • Firms may not use the extra supernormal profit to improve the
Elastic demand: the firm sets MC=MRb, it chooses output Qb and businesses; e.g. profits may be distributed to shareholders only
can charge price Pb in this sub-market Perfect price discrimination
The combined profit area of the two submarkets should exceed the profit
Firm charges each consumers exactly what they are prepared to pay
in the whole market to make the price discrimination worth it.
extracting all the consumer surplus to boost its supernormal profits
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 3 Monopolistic competition
Characteristics of monopolistic competition Monopolistic competition in the long run
• Large number of buyers and sellers (firms) In the long run, because
• Differentiated products there are low barriers to
• Low barriers to entry or exit entry, some new
• Firms are price makers - they can influence the market price because firms will join the market
products are not identical; demand to the firm slopes downwards to attracted by the
the right and MR is twice as steep as AR supernormal profit
• Supernormal profit is competed away in the long run Some consumers will
It is important to remember that the emphasis in monopolistic competition switch to the new firm's
is on competition; the low barriers to entry enable firms to join easily and product and demand for
compete in the market the existing firm will shift
Monopolistic competition in the short run inwards to AR2
The existing firm's new the profit-maximising output is at MC=MR2.
Assuming profit-
Output falls to Q2 and the price it charges falls to P2; At Q2 AC =AR2 so
maximisation, the firm
the firm is making normal profit only.
will produce the output
All supernormal profit is competed away by the entrance of the new
Q where MC=MR. It can
firms
charge price P according If the firm had been making losses in the short run, some firms would leave the
to the demand curve. At market & demand for the existing firm's product would increase
Q, AR is greater than AC,
so profit per unit is AB. Monopolistic competition & efficiency
Total supernormal profit Allocative efficiency (P>MC): firms are not allocatively efficient in either the
is the shaded area ABCP short nor the long run
Productive efficiency (min LRAC): in the long run, the firm is not producing
where the long run AC curve is at its minimum, so firms are not productively
Minimum losses in the short run efficient
If the firm faced higher costs, so AC>AR at the output where MC=MR, then Dynamic efficiency; supernormal profit is competed away in the long run making
the firm is making losses. it more difficult for firms to be dynamically efficient
• The firm will shut down if its revenue does not cover its variable costs (if One benefit to consumers is there is product differentiation – consumers have
AR< AVC) in the short run. more choice than in perfect competition; firms are expected to advertise and aim
• The firm will stay open in the short run if AR>AVC to create brand loyalty (if they succeed the barriers to entry become stronger.
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 3 Oligopoly
Characteristics of oligopoly Price war (Competitive oligopoly)
• Dominated by a small number of large sellers (firms) Firms may engage in a price war (try to undercut each other's prices) to
• High concentration ratio increase their market share.
• Most likely differentiated products Gainers in a price war Losers in price war
• Barriers to entry or exit Consumers: lower prices, higher consumer Consumers: loss of choice if firm is forced
• Firms are price makers - they can influence the market price because surplus to leave
products are not identical; demand to the firm slopes downwards to Surviving firms: gain market share and Firms: lose profit in the short run
increase longer term profit Firms: weakest firms may have to leave
the right and MR is twice as steep as AR Firms: may be able to use their monopsony Shareholders: may lose profit
• Supernormal profit is possible in the long run power to depress the prices they pay to Suppliers: may lose profit if they cannot
Concentration ratio suppliers to cut costs and stop profit falling charge such high prices
The concentration ratio measures the combined market share of a leading
Stable prices (Competitive oligopoly)
cluster of businesses in a clearly defined market e.g. the five-firm
Oligopolistic firms may decide not to compete using price, but instead use non-
concentration ratio is the sum of the market shares of the largest five firms as
price competition methods such as product differentiation, advertising and
a %. (If the 5-firm CR is 60%+ this indicates an oligopoly) marketing, product innovation, loyalty schemes, customer service, special offers,
Interdependence of firms free gifts etc.
The kinked demand curve shows why prices may not adjust when the firm's costs
Firm in oligopoly are interdependent. They have to consider how the action
change.
of one firm affects other firms. A firm's decision to change price, output, how
it competes…can impact quickly on other firms. Firms try to anticipate their EXTENSION: Kinked demand curve – explaining stable prices
rivals' decisions; there is uncertainty The firm believes that if it raises price from
P, others will not follow so its demand is
Competition v collusion elastic, but if it cuts if price, others will, so
Competitive oligopoly – the firms compete demand is inelastic.
• Price war This creates a kink in the D=AR curve; the
• Stable/sticky/rigid prices & non-price competition MR curve will therefore have a disjointed
Collusive oligopoly – the firms act as a monopoly and make agreements section.
Normally if a firm's costs rise, the firm
together on pricing and output
reduces output and increases price to
• Tacit/informal; unspoken, hard to detect; may be due to price maximise profits. Here the firm's costs can
leadership vary between MC1 and MC2 with no change
• Overt/formal/cartel; usually illegal; firms can face considerable in price; prices are sticky at P.
consequences if caught
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 3 Oligopoly: Collusion and Cartels
Collusive oligopoly Conditions for an effective cartel
Collusion: collective agreement between firms which restrict competition • Fewer, larger firms involved makes it easy to make an agreement
Overt collusion: firms openly fix prices, output etc. • High barriers to entry so cartel price cannot be undercut
Tacit collusion: ‘behind the scenes' agreements • Strong branding so consumers stick with goods when price is high
Price leadership: firms adjust their prices in line with the actions of the • Easy to monitor each firms' output to ensure adherence to quotas
market leader • Easier when demand is not volatile which could affect quotas chosen
Collusion is usually illegal and can result in big fines and prison sentences. • Easier if firms have similar cost structures (a very efficient firm could be
Whistleblowing: a firm involved in cartel behaviour has an incentive to reluctant to join a cartel)
reveal the anti-competitive pracitces; it may avoid fines imposed on other • Demand is price elastic; setting a high cartel price does not impact
firms demand much
Cartel diagram • Easier if there is a dominant firm leading the group
• Weak industry regulators and competition authorities
Why cartel behaviour is often unstable
• There is an incentive for a firm to 'cheat' (and increase output, which
would bring the cartel price down) if there is no credible threat or risk
• Supernormal profits may attract new firms if barriers to entry are not
high enough destabilising the agreement
• If market demand falls, there may be over-capacity putting downward
pressure on the price
• Regulatory and competition authorities use the law to break them up
• The colluding oligopolists act as a monopoly to maximise their joint • There is an incentive to whistle-blow
profits; the industry as a whole makes maximum monopoly profits at price
Costs and benefits of collusive behaviour
Pcartel.
• To maintain this price and profits each firm is given an output quota so Costs Benefits
their joint output does not exceed Qind. Damages consumer welfare (higher Industry standards can increase some
• All firms are 'price takers' at the cartel price Pcartel = AR=MR, the price price) social welfare
they have agreed Absence of competition reduces Could help offset monopsony power by
• The individual firm sets its output at the Quota, but this is not its profit- efficiency suppliers in cooperatives
maximising output (which is Q* where its MC=MR); it has an incentive to Reinforces monopoly power Profits may be used to improve dynamic
produce more and break the cartel agreement efficiency
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 3 Game theory
Game theory Use of game theory
Game theory can be used to model the behaviour of firms in oligopoly. Game theory can help explain the benefits of collusion (higher profits) and
It is about interdependence and strategy why collusive behaviour can be unstable (there will be a tendency towards
Pay-off matrix: a table showing the possible outcomes of a game for the the Nash Equilibrium); it helps analyse interdependent behaviour in
players depending on the strategies chosen oligopoly industries
Duopoly: an industry with two firms Game theory can be used when firms are considering whether to produce a
Pricing game high or low output; whether to install new technology or not etc..
First mover advantage: games are not always played simultaneously by the
players; one may move first giving it an advantage (or sometimes a
disadvantage)
Pricing strategies to increase market power to increase profits
Each firm has to choose between charging high price £2 or low price Predatory pricing: firm sets its price below average variable cost to force out
£1.80 a rival or prevent a new entrant (illegal)
• If they both choose £2, their profits will be £10m for Firm X and £10m Limit pricing: firm sets its price low enough to deter new entrants (AR=AC)
for firm Y (Top left) Price discrimination: firm charges a different price for the same good in
• If they both choose £1.80, their profits will be £8m for Firm X and £8m different sub-markets
for firm Y (Bottom right) The goal for firms is to increase their profits; they may take a short term hit
• If Firm X prices at £2 and Firm Y prices at £1.80, Firm X gets £5m for a longer term gain
profits and Firm Y gets £12m (Top right) Non-pricing strategies to increase market power to increase profits
• If Firm X prices at £1.80 and Firm Y prices at £2, Firm X gets £12m
• Branding/loyalty
profits and Firm Y gets £5m (Bottom left)
• Advertising
Strategy:
• New product development
• If Firm Y prices at £2 , firm X has to choose between price of £2 (would
• New production methods
give £10m profit) or £1.80 (would give £12m), so it prefers £1.80
• Product service quality & differentiation
• If Firm Y prices at £1.80, firm X has to choose between prices of £2
• Mergers/takeovers
(would give £5m profit) or £1.80 (would give £8m), so it prefers £.1.80
• Collusion
• By the same logic, Firm Y will also choose £1.80.
Many of these can act as a barrier to entry or give a firm a competitive edge.
The Nash Equilibrium is (8,8), with both charging the lower price, but this
Some may increase costs in the short term, but increase demand and revenue
is not the best outcome, (10,10) which could be achieved if they collude
in the long term
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 3 Impact on profit when costs & revenue change
Rise in fixed costs Rise in revenue
A rise in fixed costs increases the total costs of a firm. ATC curve shifts up. A rise in sales or demand increases the total revenue of a firm. AR shifts
There is no change in variable costs, so no change in MC. right and MR also shifts right (& is twice as steep as the new AR).
Original price is P1 and Original price is P1 and
output Q1 to maximise output Q1 to maximise
profit (MC=MR). profit (MC=MR)
Supernormal profits = Supernormal profits = area
area 0Q1 x C1P1. 0Q1 x C1P1
The rise in fixed costs The increase in demand
shifts AC up from AC1 to shifts AR1 out to AR2 nad
AC2. MR1 out to MR2.
The profit-max output The new profit-max output
and price is unchanged, and price are Q2 and P2,
but supernormal profit and supernormal profit
falls to 0Q1 x C2P1 rises to 0Q2 x C2P2
Rise in variable costs Falling fixed and variable costs and fall in revenue
A rise in variable costs increases the total costs of a firm. ATC curve shifts up.
There is also an increase in MC because marginal costs are always variable. The analysis in the diagrams can be reversed for changes in the opposite
Original price is P1 and direction:
output Q1 to maximise profit Fall in fixed costs = AC shifts down
(MC=MR) • No change in profit maximising output and price
Supernormal profits = area • Increase in supernormal profits
0Q1 x C1P1 Fall in variable costs = AC and MC shift down
The rise in variable costs • Profit maximising output increases, profit maximising price falls
shifts up AC1 to AC2 and MC1 • Increase in supernormal profits
up to MC2 Decrease in revenue = AR and MR shift inwards
The new profit-max output • Profit maximising output falls, profit maximising price falls
and price are Q2 and P2 and • Decrease in supernormal profits
supernormal profit falls to TIP: It is always worth thinking about the most likely outcome if costs rise and revenue
fall, then a fall in profit seems likely, check your diagram shows this! (and vice versa)
0Q2 x C2P2
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 3 Contestability
Traditional theory of the firm Characteristics of contestable markets
• Low barriers to entry & exit and no sunk costs
• Equal access to technology – existing firms do not have an advantage
• No collusion
• Weak brand loyalty
It does not matter how many firms are in the industry, but there must be free/easy entry
and exit into and out of the industry
How contestable markets work
• Existing or incumbent firms (i.e. firms already in the industry) are under
constant threat of competition as there are no/low barriers to entry and exit
• If this threat of potential competition is credible, firms (even a monopoly) will
Traditional theory of the firm implies that as the number of firms in the industry gets have to behave more competitively or new firms will join to try and compete
smaller, there will be less competition, higher barriers to entry and potentially higher for a share of the supernormal profits
prices for consumers. Baumol's contestable market theory challenges this • Existing firms might choose limit pricing over profit maximisation
• They may also focus on non-price competition
Contestable market terms • New entrant(s) might go for sales growth max – in a bid to establish a market
foothold; entry can also be 'hit-and-run' from a challenger firm
Contestable market: where a new market entrant has equal access to all
production techniques available to the incumbents and where entry Under threat of competition, the
decisions can be reversed without cost. monopoly may limit price; it increases
Barriers to entry: anything that blocks potential entrants from entering a output from Qmon to Qlim and cuts its
market profitably. price from Pmon to Plim; its
Barriers to exit: costs associated with leaving an industry. supernormal profits (shaded) become
Sunk costs: sunk costs are costs that cannot be recovered (in whole or in normal profit only; it may reverse this
part) if a business decides to leave an industry. if the threat of entry disappears
Hit-and-run entry: when a business enters an industry to take advantage
of temporarily high (supernormal) market profits.
Limit pricing: firm sets its price low enough to deter new entrants Contestable markets & efficiency
(AR=AC). Contestable markets can bring benefits of competitive markets:
Non-price competition: competing with product differentiation, quality, • Lower prices (improved allocative efficiency)
• Incentives for firms to cut costs (improved x-efficiency)
brand advertising, product design and packaging, customer service, and • Incentives for firms to innovate (dynamic efficiency)
the provision of complementary products or services but not price. • Scope for economies of scale (large firms can exist!)
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 3
Labour markets
Labour demand Shifts in labour demand and supply
Demand for labour is derived demand – it is linked to the demand for final
goods/services.
Firms will demand more labour at lower wages than at higher wages; the labour
demand curve slopes downwards to the right.
Shifts in labour demand
• Firms demand labour; if demand for their output increases, their
demand for labour is likely to increase too
• If workers are more productive, the demand for labour increases
• Demand for labour can be affected by the price of substitute resources
e.g. if capital becomes more expensive, firms will demand more labour Labour supply shifts right from S1 to S2; Labour demand shifts right from DL1 to
Labour supply there is an excess supply at original wage DL2; there is an excess demand at original
The supply of labour is greater at higher wages than lower wages; the labour W1; the wage starts to fall and firms wage W1; the wage starts to rise and more
supply curve slopes upwards to the right. employ more workers (extension in labour workers extend their labour supply until the
Shifts in labour supply demand) until the new equilibrium at Q2 new equilibrium at Q2 and wage W2 is
and wage W2 is reached. reached.
• Changes in the non-monetary/non-pecuniary benefits of work
• Changes in working conditions
• Changes in taxation and welfare benefits Wage elasticity of demand
• Changes in the wages of different occupations Wage elasticity of demand: the responsiveness of quantity of labour
• The occupational and geographical mobility of labour demanded to a change in the wage rate.
• The role of trade unions and professional bodies WED = % change in Q of labour demanded/% change in wage
• Net immigration WED depends on: % of total costs that are labour costs; the ease and cost of
Wage determination in competitive markets factor substitution, the PED of the final product and the time period etc.

The wage is determined by the Wage elasticity of supply

interaction of labour demand and Wage elasticity of supply: the responsiveness of quantity of labour supplied
labour supply. to a change in the wage​ rate.
If labour demand or labour supply WES = % change in Q of labour supplied/% change in wage
shifts, the market will adjust to the new WES depends on: nature of skills and qualifications required to work in an
equilibrium wage and employment industry, the vocational nature of work, the time period, the occupational
and geographical mobility of labour.
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: Labour markets: individual labour supply; public sector pay; NMW
THEME 3 Backward bending individual labour supply National minimum wage
An individual worker's labour supply curve may bend backwards;
It is assumed that hours worked (earning a wage) is a substitute for The NMW is a legally imposed price
leisure. The substitution effect of a wage change: as the wage rises, the floor in labour markets. To have an
impact in a labour market it must be
worker prefers hours worked to leisure because the opportunity cost of
above the market equilibrium.
taking leisure is higher (and vice versa for a wage fall)
Initially the wage rate is W1 and Q1 is
The real income effect of a wage change: as the wage rises, a worker may the quantity of labour. After the NMW,
hit their target income and choose to work fewer hours (and vice versa) the wage rises to W2, but the demand
If the real income effect is greater than the substitution effect then the for labour falls to Q2; there is a fall in
labour supply may bend back – it is usually assumed this only happens at employment ofQ1Q2
higher wages.
Backward bending labour supply diagram The NMW attracts more workers into the labour market – there is an extension
along the labour supply; The overall impact is some real wage unemployment
Only an individual's labour supply can of Q2Q3
slope backwards:
It is more likely to slope backwards for Benefits of a NMW
• Fairer pay, less discrimination; less poverty, less worker exploitation
those on high incomes, for those who can
• May not cause unemployment if the economy is growing, if better pay boosts
adjust their hours of work, for those who productivity or if it increases spending by lower paid (with a high MPC) in the
are not primary income earners & for economy (higher AD increases the demand for labour)
those who do not like their job. • Helps reduce income inequality
• Incentivises more workers to search for work & join labour market
Wage setting in the public sector
• Lower costs of welfare for government
Through public sector wage setting, a government can impact the labour
Costs of a NMW
market. For example, if wage rates are increased in the public sector relative
• May cause real wage unemployment
to those in the private sector, then private sector businesses may be forced
• Only covers employees; self-employed in the gig economy may be paid less
to increase wages to retain workers. • Increases costs to businesses; may speed up automation causing
Governments can also freeze public sector pay or increase it at a rate below technological unemployment
inflation (real pay cut) to put downward pressure on inflation or to reduce • Could become inflationary if other workers try to maintain pay differentials
government borrowing. with lower paid workers
Public sector workers who are unhappy with a real pay cut may take • Less international competitiveness (adds to business costs)
industrial action, e.g. Junior doctor strike 2023-24 • Does not tackle many aspects of poverty reduction
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 3 Labour markets: Wage differentials
Wage differentials Pay gaps

Wage differential: the difference in wages between workers with different Pay gap: the difference in earnings between different groups of
skills in the same industry, or between workers with comparable skills in people e.g. women, ethnic minorities earning less
different industries or localities. Gender pay gap: the difference between average hourly earnings
Compensating wage differentials: a reward for risk-taking, working in poor (excluding overtime) of men and women as a proportion of average
conditions and during unsocial hours. hourly earnings (excluding overtime) of men’s earnings
Reward for human capital: differentials compensate workers for Other pay gaps: there can be disparities in income based on factors such
(opportunity and direct) costs of human capital acquisition. as race and ethnicity, and disability
Differences in labour productivity and revenue creation: workers whose Discrimination: due to gender, race, age, sexual orientation,
efficiency is high and generate revenue for a firm often have higher pay. socioeconomic groups
Trade unions' collective bargaining power: used to achieve a mark-up on Causes of pay gaps:
wages compared to non-union members • Discrimination
Artificial barriers to labour supply: such as professional exams, migration • Occupational segregation
controls • Educational and occupational choices
Employer discrimination: employers may perceive older workers as less • Work experience and seniority
able to learn new tasks, less flexible, and less ambitious & pay lower wages • Negotiation and salary transparency
• Unconscious bias
Diagram showing wage differentials • Parental and caregiving responsibilities
• Lack of workplace flexibility and inclusion

Discrimination diagram
• DL is the labour demand curve
without discrimination or
unconscious bias; the wage is W
• With discrimination, employers
'assume' the group is less
productive and so the demand is
less at DL* reducing the wages
for the group to W*
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 3 Labour markets: non-competitive labour markets
Trade unions Factors influencing trade union power
Trade union: an organised group of employees who work together to  Macroeconomic climate
represent and protect the rights of workers, usually by using collective  Public support and sympathy
bargaining techniques.  Union density
Trade unions aim to gain better wages, protect jobs, improve non-monetary  TU legislation
aspects of jobs e.g. pension rights, protect against unfair dismissal, ensure  Financial consequences of industrial action
health and safety at work, counterbalance any monopsony power etc.  Globalisation (MNCs can outsource to other parts of the world)
Trade union wage effect Benefits of costs of trade unions
If the trade union gains a Arguments for TUs: Arguments against TUs:
wage above the market Better wages and working conditions Reduces employment flexibility
equilibrium, the wage for its Trade union wage premium = higher Prevents efficient working of labour
members rises to WTU, but it wages markets
may cause some real wage Lower wage inequality Adds to business costs if wage is
unemployment of Q2Q3. Ensure real wages are not eroded higher with no improvement in
The gap between wages of TU Counterbalances monopsony power productivity
members and non-members = of employers Reduces profits of companies
the trade union wage Can improve industrial relations if Can delay introduction of new
premium union works well with management technology
Monopsony employers
Some employers have monopsony (buying) power in some labour markets,
Factors making it easier for a trade union to gain a pay increase with no job loss
e.g. the government is the main employer health care workers.
• Labour is a small percentage of total costs Just as a monopoly can increase its profits by reducing output and raising the
• Impossible or difficult to substitute labour with other factors of price in a product market, a monopsonist can depress wages and restrict
production employment in a labour market to make more profit from employing workers.
• Demand for the final product is price inelastic (costs can be passed on by • A trade union can push wages AND employment up in a monopsony labour
firm to consumers) and/or increasing market because it is effectively making it more competitive
• Trade unions control the supply of labour (closed shops) • The introduction of a minimum wage also can achieve this in a monopsony.
• Firm is already making substantial profits TUs and the NMW can act as a way of counterbalancing monopsony power
• Pay claim is accompanied by a productivity rise (labour demand may shift and achieving fairer pay and less exploitation of workers, though it the
right too) wage rise is rapid it can still cause unemployment
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 3 Labour markets: efficiency and policies
Competitive labour market Policies to reduce discrimination
For a labour market to be competitive it has: Anti-discrimination laws and regulations: enforce and strengthen existing
• Many buyers (employers) and sellers (workers) anti-discrimination laws that prohibit discrimination (the Equal Pay Act)
• Perfect information Affirmative action / diversity initiatives by employers
• Homogeneous labour Access to quality education and training: provide opportunities for
• Mobility of labour individuals from marginalised groups to acquire the skills needed to access
• No monopsony power higher-paying jobs. Reform entry to universities.
Wages are determined by the interaction of demand and supply; the market
The gig economy
will adjust to changes in the conditions of labour demand and supply.
Gig economy: businesses that operate digital platforms/apps – which allow
Non-competitive labour markets
individuals to undertake jobs, or ‘gigs’, for end-user e.g. Uber and Deliveroo.
Most labour markets are not competitive because of: The gig economy has grown with the rise of technology and the increased
• Monopsony employer demand for flexible work arrangements, including zero hours contracts.
• Barriers to entry It benefits employers who can offer lower wages and reduce their costs. It
• Information asymmetry between employer and workers offers workers more flexible hours, but there is less employment protection
• NMW and fewer employment benefits; a lack of job security.
• Trade unions & collective bargaining
• Lack of labour mobility (geographical & occupational) Labour Migration
• Discrimination Labour migration: cross-border migration of people from one country to
• Employment laws/regulations another
Policies to increase labour mobility Immigration: people entering a country to live/work/study
Emigration: people leaving a country to live/work/study
Geographical mobility is the ability of labour to move around an area, region Benefits of net immigration: more skilled workers & higher productivity;
or country in order to work. increase in labour supply (LRAS shifts out); can drive innovation and
Policies to improve geographical mobility: regional policy, investment in entrepreneurship; migrants can add to AD; positive multiplier effects; fill
transport infrastructure, addressing difference in house prices etc. skills gaps; remittances sent home may be used to buy exports; higher tax
Occupational mobility is the ability of labour to switch between different revenue.
occupations. Occupational mobility is affected by the level of transferable Costs of net immigration: welfare costs and greater demand for public
skills and educational requirements of jobs etc. services; possible displacement of some domestic workers; social tensions;
Policies to improve occupational mobility: more & better education and higher demand for housing raising house prices and rents; risk of poverty
training, investment in schools and universities etc. and exploitation for migrants.
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 3 Competition Policy & Regulation
Aims of Competition Policy Competition policy in UK
Approach is pragmatic – case-by-case regulation
• Promote competition for the benefit of consumers
• Tax incentives/grants to attract FDI and promote small business activity
• Consumers get lower prices and better quality
• Deregulation/privatisation/competitive tendering
• The most innovative, consumer-focused companies are the
• Trade liberalisation
ones that survive; promotes dynamic efficiency
• Break-up monopolies (though may lose economies of scale)
• Investigate (potential) mergers to ensure that the
• Nationalise; impose marginal cost pricing on natural monopolies
outcome won’t reduce consumer welfare
• Local sourcing and employment laws to reduce monopsony power
• Investigate entire markets if there are problems for consumers,
• Regulations and laws (e.g. Competition Act)
especially in concentrated markets
• Block/approve mergers
• Initiate action against companies involved in cartels or other illegal Price regulation
anti-competitive practices e.g. bid-rigging, collusion, predatory pricing
• Encourage market liberalisation e.g. deregulation, to improve UK uses an RPI-x formula for pricing
contestability, make markets work more efficiently • If business costs rise at RPI, then profits will fall incentivising greater
• Analyse “state aid” measures to make sure it is fair and doesn’t distort productive efficiency
competition • For some industries, an RPI+k formula is used; encourages more
• Protect consumers from “unfair” trading practices investment
• Encourage the government and regulators to promote competition • RIIO = revenue = incentives, innovation and outputs
Advantages of price regulation: reduces monopoly power, less consumer
exploitation; greater efficiency, helps control inflation
Competition Policy in the UK: Regulation
Disadvantages of price regulation: possible job loss, distorts price
Overseen by the independent Competition and Markets Authority mechanism, there may be information failure & regulatory capture; lower
(CMA) and supported by a range of regulators​, e.g. OFCOM, OFWAT, FCA, profits may mean less investment
OFGEM etc. Profit regulation
The role of the CMA & the regulators is: Profit regulation considers the size of firms and evaluates a 'reasonable' rate
• Monitor & regulate prices via price caps of return from the capital base; more common in USA.
• Set standards for services/performance If profit exceeds this rate, the regulator imposes price cuts or a one-off
• Ensure competition/contestability increases; reduce barriers to entry (windfall) tax.
• Correct market failure by acting as a 'surrogate competitor' to bring Advantages: prevents profiteering; less consumer exploitation
prices and profits to those similar to a competitive market Disadvantages: discourages profits; encourages 'cost padding'; no efficiency
• Arbitrate between producers' and consumers' interests incentive' scope for regulatory failure
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 3 Regulatory failure and nationalisation
Policy interventions Arguments against nationalisation
Interventions can be evaluated by considering their impact on price, profit, • Diseconomies of scale
efficiency, quality/performance, choice, jobs, the environment, R&D, • Lack of competition (higher prices, less choice)
investment etc. • Lack of incentives to minimise costs (X-inefficiency)
• Lack of supernormal profit (less innovation, less dynamic inefficiency?)
Regulatory failure • Risk of moral hazard (e.g. bail outs for banks post-GFC)
Key reasons why regulation may fail: • Taxpayers 'fund' any losses
• Regulatory capture: a form of government failure; it happens when a • Regulation of privatised industries may work better than full
government agency operates in favour of producers rather than nationalisation
consumers. Also known as a form of political capture or "cronyism." How marginal cost pricing works
• Asymmetric information/information gap: the industry may have more
information than its regulators and use this to reduce regulation Private monopoly charges P1
• Inadequate resources for the regulators and produces Q1 (at
• Insufficient power given to the regulators MC=MR); supernormal profit
shaded blue
Government intervention: nationalisation Nationalised monopoly sets
Nationalisation: the transfer of ownership of assets/businesses from the P=MC; price falls to P2 and
private sector to the state (public) sector. Reasons for output increases to Q2, but
nationalisation include: supernormal profits are
• Improve health & safety standards lower (pink shaded)
• National interest / strategic industries
• Improve equality (of opportunity)
Natural monopoly has falling LRAC
• “Too big to fail” i.e. collapse / failure would be too risky for the
and MC curves. If private, it charges
economy
P1 and produces Q1 (at MC=MR);
• To gain economies of scale (productive efficiency)
supernormal profit shaded blue
• To increase allocative efficiency (MC pricing)
Nationalised natural monopoly sets
• May take externalities into account in decision-making
P=MC; price falls to P2 and output
• Better industrial relations
increases to Q2, but minimum
Examples of industries that have been nationalised include public utilities
losses are shaded pink
such as water, energy, rail, though these are all currently privatised in the
UK.
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 3 Privatisation
Privatisation Deregulation
Privatisation: the transfer of ownership of assets / businesses from the state
Deregulation of industries: reducing or removing government-imposed
(public) sector to the private sector. It can be ‘partial’ or full. Forms of
restrictions and regulations on businesses, with the aim of promoting
privatisation include:
competition, efficiency, and innovation
▪ Contracting out/outsourcing Advantages include increased competition, Disadvantages include: reduced safety and
▪ Public Private Partnerships (PPPs) lower prices and better services for quality as companies may prioritise
▪ Private Finance Initiative (PFI) consumers, improved allocative efficiency; profits; increased inequality, large
more innovation, improved dynamic companies may dominate the market and
▪ Competitive tendering efficiency; more economic growth, increased small businesses may struggle to compete;
capital investment , new jobs, improved long reduced consumer
Advantages of privatisation run aggregate supply protection; environmental costs, negative
• Profit motive can lead to improved efficiency and more focus on (LRAS); greater consumer choice, new externalities, such as pollution, and social
companies can enter the market and existing problems, such as job losses, as companies
consumer needs, which supports long-term growth companies can expand their offerings; may not be held accountable for their
• Can lead to greater competition and in turn innovation contestability can lead to an improvement in actions.
• Potential for lower prices, higher quality​ and more choice for consumers economic welfare
• Potential for less bureaucracy State ownership v private ownership
• Investment decisions are market-led
• Ownership of a business (state or private) is probably less significant than the extent
• May disperse share ownership; businesses have to deliver shareholder to which an industry is genuinely contestable
value • Quality of regulation is also important – a regulator can act as a surrogate consumer
• Short term boost to government finances • Distinguish between network (natural monopoly) and final mile service (can be more
• May create firms that can become global competitors competitive) e.g. water & telecoms
• Try not to assume that the private sector is always more efficient & innovative than
Disadvantages of privatisation the state
• Government can lose an important revenue source • Does more competition always lead to benefits for consumers? Are there examples of
• May lead to privatised natural monopolies which struggle to survive where less competition might be better?
• Risk of private monopolies exploiting consumers, and needing • Who gains and who loses from rising contestability?
(expensive and often ineffectual) regulation • Why might competition authorities not always “get it right”?
• May be a short-term focus because shareholders are focused on • What are the best methods that competition authorities can use to improve consumer
welfare in different markets?
dividends • What is the impact of privatisation on markets, consumer welfare, equality and the wider
• Essential public services should arguably not be run for profit economy?
• Externalities may be ignored in decision-making • What factors might a government consider when thinking about nationalising
• May be unclear whether objective is more competition or more profit an industry/firm?