A2 microeconomics course companion

A2 Economics
Microeconomics
Course Companion
2009

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http://www.tutor2u.net/blog/index.php/economics/
Introduction to the A2 Microeconomics Study Companion
Welcome to this 2008-09 edition of the Tutor2u A2 microeconomics study companion. The edition
has been revised throughout and seeks to provide a comprehensive coverage of some of the key
ideas in the A2 business economics courses together with coverage of environmental market failure
issues and aspects of labour market economics.
The digital version of this study companion contains many links to selected online resources such as
recent news articles from recommended newspapers and magazine. And also to the Tutor2u
economics blog so that when you click on such a link, you will be guaranteed to be taken to the latest
blog features written after this study companion was completed.
This study companion is designed as a complement to your studies in A2 Economics and should not
be regarded as a substitute for taking effective notes in your lessons. Points raised and issues
covered in class analysis and discussion invariably go beyond the confines of this guide. And with
Economics being the subject that it is, events and new economic policy debates will inevitably
surface over the next twelve months that take you into new and exciting territory.
Economics is a dynamic subject, the issues change from day to day and there is a wealth of
comment and analysis in the broadsheet newspapers, magazines and journals that you can delve
into. The more reading you manage on the main issues of the day the wider will be your appreciation
of the theory and practice of economics.
Further resources including online tests and revision notes are available from the Tutor2u virtual
learning environment (VLE) at http://vle.tutor2u.net Check to see if your school or college has a
subscription to this resource and EconoMax Tutor2u‘s digital magazine for Economics.
I acknowledge the help given in the preparation of this study companion by my own students and I
also acknowledge some of the ideas and arguments put forward in articles written by Bob Nutter, Jim
Riley, Liz Veal and Mark Johnston – some of my fellow writers for the EconoMax digital magazine
from which a small number of articles have been adapted as mini case studies.
Good luck with your studies
Geoff Riley
This study companion follows the AQA syllabus and chapters are grouped into five main sectors:
1. The Firm: Objectives, Costs and Revenues
2. Competitive Markets
3. Concentrated Markets
4. The Labour Market
5. Government Intervention in the Market

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Contents
1. Production in the Short and the Long Run ..................................................................................4
2. How can we calculate the costs of a firm? ..................................................................................8
3. Long Run Costs: Economies and Diseconomies of Scale........................................................13
4. Business Revenues ...................................................................................................................23
5. Profits .........................................................................................................................................26
6. What Objectives Do Firms Have? .............................................................................................34
7. Divorce between Ownership and Control..................................................................................38
8. Technological Change, Costs and Supply in the Long-run.......................................................42
9. The Growth of Firms ..................................................................................................................45
10. Perfect Competition ...................................................................................................................51
11. Monopolistic Competition...........................................................................................................59
12. The Model of Monopoly .............................................................................................................62
13. Barriers to Entry and Exit in Markets.........................................................................................65
14. Price Discrimination ...................................................................................................................69
15. Monopoly and Economic Efficiency...........................................................................................76
16. Collusive and Non-Collusive Oligopoly .....................................................................................84
17. Oligopoly and Game Theory......................................................................................................90
18. Contestable Markets ..................................................................................................................97
19. Monopsony Power in Product Markets....................................................................................101
20. Consumer and Producer Surplus ............................................................................................103
21. Price Takers and Price Makers – Pricing Power.....................................................................106
22. Competition Policy and Regulation..........................................................................................111
23. Privatisation and Deregulation.................................................................................................116
24. The Labour Market...................................................................................................................124
25. Monopsony in the Labour Market ............................................................................................137
26. Discrimination in the Labour Market ........................................................................................139
27. Trade Unions in the Labour Market .........................................................................................142
28. The Distribution of Income and Wealth ...................................................................................146
29. Market Failure - Externalities...................................................................................................153
30. Carbon Emissions Trading and the Stern Review ..................................................................159
31. Cost Benefit Analysis...............................................................................................................165

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1. Production in the Short and the Long Run
We take it for granted that goods and services will be available for us to buy as and when we need
them. But production and supplying to the market is often a complicated business.
Production Functions
The production function elates the quantity of factor inputs to the volume of outputs that result.
We make use of three measures of production and productivity.
o Total product means total output. In most manufacturing industries such as motor vehicles,
motor homes and DVD players, it is straightforward to measure production from labour and
capital inputs. But in many service or knowledge-based industries, where the output is less
―tangible‖ or perhaps ‗weightless‘ we find it harder to measure productivity.
o Average product measures output per-worker-employed or output-per-unit of capital.
o Marginal product is the change in output from increasing the number of workers used by one
person, or by adding one more machine to the production process in the short run.
The length of time required for the long run varies from sector to sector. In the nuclear power industry
for example, it can take many years to commission new nuclear power plant and capacity. This is
something the UK government has to consider as it reviews our future sources of energy.
Short Run Production Function
The short run is a time period where at least one factor of production is in fixed supply - it
cannot be changed. We normally assume that the quantity of plant and machinery is fixed and that
production can be altered through changing variable inputs such as labour, raw materials and
energy.
The time periods used in economics must differ from one industry to another. The short-run for the
electricity generation industry or telecommunications differs from magazine publishing and local
sandwich bars. If you are starting out in business this autumn with a new venture selling sandwiches
and coffees to office workers, how long is your short run? And how long is your long run? (!!). The

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long run could be as short as a few days – enough time to lease a new van and a sandwich making
machine!
Diminishing Returns
In the short run, the law of diminishing returns states that as we add more units of a variable input
to fixed amounts of land and capital, the change in total output will at first rise and then fall.
Diminishing returns to labour occurs when marginal product of labour starts to fall. This means that
total output will be increasing at a decreasing rate.
What happens to marginal product is linked directly to the productivity of each extra worker. Beyond
a certain point new workers will not have as much capital to work with so – it becomes diluted
among a larger workforce. As a result, the marginal productivity tends to fall – this is the principle of
diminishing returns. An example is shown below. We assume that there is a fixed supply of capital
(20 units) available in the production process to which extra units of labour are added.
Initially the marginal product is rising – e.g. the 4th
worker adds 26 to output and the 5th
worker
adds 28.
It peaks when the sixth worked is employed when the marginal product is 29.
Marginal product then starts to fall. At this point production demonstrates diminishing returns.
The Law of Diminishing Returns
Capital Input Labour Input Total Output Marginal Product Average Product of Labour
20 1 5 5
20 2 16 11 8
20 3 30 14 10
20 4 56 26 14
20 5 85 28 17
20 6 114 29 19
20 7 140 26 20
20 8 160 20 20
20 9 171 11 19
20 10 180 9 18

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Average product rises as long as the marginal product is greater than the average – for example
when the seventh worker is added the marginal gain in output is 26 and this drags the average up
from 19 to 20 units. Once marginal product is below the average as it is with the ninth worker
employed (where marginal product is only 11) then the average must decline.
This is an important example of the relationship between marginal and average values that we will
return to later on when studying costs and revenues.
Criticisms of the Law of Diminishing Returns
How realistic is this assumption of diminishing returns? Surely ambitious and successful businesses
will do their level best to avoid such a problem emerging?
It is now widely recognised that the effects of globalisation and the ability of trans-national
corporations to source their inputs from more than one country and engage in transfers of
business technology, makes diminishing returns less relevant. Many businesses are multi-plant
meaning that they operate factories in different locations – can switch output to meet changing
demand.
A rise in productivity and the production function
In the following diagram we trace the effects of a rise in the productivity of the labour force at each
level of employment.
If average productivity rises, then the production curve shifts upwards.
Diminishing returns are still assumed to exist in this diagram as shown by the shape of the
production curve, but total output is higher for each number of people employed.
If productivity rises, for a given level of wages, this will cause a fall in the unit labour costs of
production.
Other things remaining the same, there is an inverse relationship between productivity and cost.
This is an important relationship for businesses to understand when they are seeking efficiency gains
as a means of boosting profits.
Long Run Production - Returns to Scale
In the long run, all factors of production are variable. How the output of a business responds to a
change in factor inputs is called returns to scale.
Numerical example of long run returns to scale
Total
Output
(Q)
Units of Labour Employed (L)
(Q)Slope of the curve gives the
marginal product of labour
Diminishing returns are apparent
here – total output is rising but at a
decreasing rate

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Units of
Capital
Units of
Labour
Total
Output
% Change in
Inputs
% Change in
Output
Returns to Scale
20 150 3000
40 300 7500 100 150 Increasing
60 450 12000 50 60 Increasing
80 600 16000 33 33 Constant
100 750 18000 25 13 Decreasing
In our example when we double the factor inputs from (150L + 20K) to (300L + 40K) then the
percentage change in output is 150% - there are increasing returns to scale.
In contrast, when the scale of production is changed from (600L + 80K0 to (750L + 100K)
then the percentage change in output (13%) is less than the change in inputs (25%) implying
a situation of decreasing returns to scale.
Increasing returns to scale occur when the % change in output > % change in inputs
Decreasing returns to scale occur when the % change in output < % change in inputs
Constant returns to scale occur when the % change in output = % change in inputs
The nature of the returns to scale affects the shape of a business‘s long run average cost curve.

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2. How can we calculate the costs of a firm?
In this chapter we look at production costs. In the short run, because at least one factor of
production is fixed, output can be increased only by adding more variable factors.
Fixed costs
Fixed costs do not vary directly with the level of output
Examples of fixed costs include the rental costs of buildings; the costs of leasing or purchasing
capital equipment such as plant and machinery; the annual business rate charged by local
authorities; the costs of full-time contracted salaried staff; the costs of meeting interest payments on
loans; the depreciation of fixed capital (due solely to age) and also the costs of business insurance.
Fixed costs are the overhead costs of a business.
Key points:
 Total fixed costs (TFC) these remain constant as output increases
 Average fixed cost (AFC) = total fixed costs divided by output
Average fixed costs must fall continuously as output increases because total fixed costs are
being spread over a higher level of production. In industries where the ratio of fixed to variable costs
is extremely high, there is great scope for a business to exploit lower fixed costs per unit if it can
produce at a big enough size. Consider the Sony PS3 or the new iPhone where the fixed costs of
developing the product are enormous, but these costs can be divided by millions of individual units
sold across the world. Successful product launches and huge volume sales can make a huge
difference to the average total costs of production.
Please note! A change in fixed costs has no effect on marginal costs. Marginal costs relate only to
variable costs!
Variable Costs
Variable costs are costs that vary directly with output.
Examples of variable costs include the costs of raw materials and components, the wages of part-
time staff or employees paid by the hour, the costs of electricity and gas and the depreciation of
capital inputs due to wear and tear. Average variable cost (AVC) = total variable costs (TVC) /output
(Q)
Average Total Cost (ATC or AC)
Average total cost is the cost per unit produced
Average total cost (ATC) = total cost (TC) / output (Q)
Marginal Cost
Marginal cost is the change in total costs from increasing output by one extra unit.
The marginal cost of supplying an extra unit of output is linked with the marginal productivity of
labour. The law of diminishing returns implies that marginal cost will rise as output increases.
Eventually, rising marginal cost will lead to a rise in average total cost. This happens when the rise in
AVC is greater than the fall in AFC as output (Q) increases.
A numerical example of short run costs is shown in the table below. Fixed costs are assumed to be
constant at £200. Variable costs increase as more output is produced.

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Output
(Q)
Total Fixed
Costs (TFC)
Total Variable
Costs (TVC)
Total Cost Average Cost
Per Unit
Marginal Cost
(the change in total
cost from a one unit
change in output)
(TC= TFC +
TVC)
(AC = TC/Q)
0 200 0 200
50 200 100 300 6 2
100 200 180 400 4 2
150 200 230 450 3 1
200 200 260 460 2.3 0.2
250 200 280 465 1.86 0.1
300 200 290 480 1.6 0.3
350 200 325 525 1.5 0.9
400 200 400 600 1.5 1.5
450 200 610 810 1.8 4.2
500 200 750 1050 2.1 4.8
In our example, average cost per unit is minimised at a range of output - 350 and 400 units.
Thereafter, because the marginal cost of production exceeds the previous average, so the
average cost rises (for example the marginal cost of each extra unit between 450 and 500 is
4.8 and this increase in output has the effect of raising the cost per unit from 1.8 to 2.1).
An example of fixed and variable costs in equation format
If for example, the short-run total costs of a firm are given by the formula
SRTC = $(10 000 + 5X2
) where X is the level of output.
The firm‘s total fixed costs are $10,000
The firm‘s average fixed costs are $10,000 / X
If the level of output produced is 50 units, total costs will be $10,000 + $2,500 = $12,500
The Shape of Short Run Cost Curves
When diminishing returns set in (beyond output Q1) the marginal cost curve starts to rise. Average
total cost continues to fall until output Q2 where the rise in average variable cost equates with the fall
in average fixed cost. Output Q2 is the lowest point of the ATC curve for this business in the short
run. This is known as the output of productive efficiency.

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Key point: The marginal cost curve must intersect the average curves at their minimum levels
A change in variable costs
A rise in the variable costs of production – perhaps due to a rise in oil and gas prices or a rise in the
national minimum wage - leads to an upward shift both in marginal and average total cost. The firm is
not able to supply as much output at the same price. The effect is that of an inward shift in the supply
curve of a business in a competitive market.
Costs
Output (Q)
Average Fixed
Cost (AFC)
Average
Variable Cost
(AVC)
Average Total
Cost (ATC)
Marginal Cost
(MC)
If marginal cost is below average cost then average must be falling. Even if MC is rising, AC falls
if MC <AC. For this reason, MC curve intersects the AC curve at the lowest point of the AC
curve. Diminishing returns starts to occur when marginal cost starts to rise.
Q1 Q2

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An increase in fixed costs has no effect on the variable costs of production. This means that only the
average total cost curve shifts. There is no change on the marginal cost curve leading to no change
in the profit maximising price and output of a business. The effects of an increase in the fixed or
overhead costs of a business are shown in the diagram below.
Suggestions for background reading on changes in business costs
Cadbury‘s plans to increase prices (BBC news, February 2008)
Dry cleaners facing rising costs (BBC news, June 2008)
Grain prices are squeezing bakers (BBC news, April 2008)
Costs
Output (Q)
Average
Variable Cost
(AVC1)
Average Total
Cost (ATC1)
Marginal Cost
(MC1)
MC2 AC2
AVC2
Costs
Output (Q)
AC1
MC
AC2 (after rise
in fixed costs)

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Milk costs hit Stilton producers (BBC news, July 2007)

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3. Long Run Costs: Economies and Diseconomies of Scale
Economies of Scale
Economies of scale are the cost advantages from expanding the scale of production in
the long run. The effect is to reduce average costs over a range of output.
These lower costs represent an improvement in productive efficiency and can also give a
business a competitive advantage in the market-place. They lead to lower prices and higher
profits – a positive sum game for producers and consumers.
We make no distinction between fixed and variable costs in the long run because all factors
of production can be varied. As long as the long run average total cost (LRAC) is declining,
economies of scale are being exploited.
Long Run Output (Units) Total Costs (£s) Long Run Average Cost (£ per unit)
1000 12000 12
2000 20000 10
5000 45000 9
10000 80000 8
20000 144000 7.2
50000 330000 6.6
100000 640000 6.4
500000 3000000 6
Returns to scale and costs in the long run
The table below shows how changes in the scale of production can, if increasing returns to scale
are exploited, lead to lower long run average costs.
Factor Inputs Production Costs
(K) (La) (L) (Q) (TC) (TC/Q)
Capital Land Labour Output Total Cost Average
Cost
Scale A 5 3 4 100 3256 32.6
Scale B 10 6 8 300 6512 21.7
Scale C 15 9 12 500 9768 19.5
Costs: Assume the cost of each unit of capital = £600, Land = £80 and Labour = £200
Because the % change in output exceeds the % change in factor inputs used, then, although total
costs rise, the average cost per unit falls as the business expands from scale A to B to C.

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Increasing Returns to Scale
Much of the new thinking in economics focuses on the increasing returns available to a company
growing in size in the long run.
An example of this is the computer software business. The overhead costs of developing new
software programs such as Microsoft Vista or computer games such as Halo 3 are huge - often
running into hundreds of millions of dollars - but the marginal cost of producing one extra copy for
sale is close to zero, perhaps just a few cents or pennies. If a company can establish itself in the
market in providing a piece of software, positive feedback from consumers will expand the installed
customer base, raise demand and encourage the firm to increase production. Because the marginal
cost is so low, the extra output reduces average costs creating economies of size.
Lower costs normally mean higher profits and increasing financial returns for the shareholders. What
is true for software developers is also important for telecoms companies, transport operators and
music distributors. We find across so many different markets that a high percentage of costs are fixed
the higher is demand and output, the lower will be the average cost of production.
Long Run Average Cost Curve
The LRAC curve (also known as the „envelope curve‟) is usually drawn on the assumption of their
being an infinite number of plant sizes – hence its smooth appearance in the next diagram below.
The points of tangency between LRAC and SRAC curves do not occur at the minimum points of the
SRAC curves except at the point where the minimum efficient scale (MES) is achieved.
If LRAC is falling when output is increasing then the firm is experiencing economies of scale. For
example a doubling of factor inputs might lead to a more than doubling of output.
Conversely, When LRAC eventually starts to rise, the firm experiences diseconomies of scale, and,
If LRAC is constant, then the firm is experiencing constant returns to scale
LRAC
SRAC1
SRAC2
SRAC3
Costs
AC1
AC2
AC3
Q2 Q3 Output (Q)Q1

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There are many different types of economy of scale. Depending on the characteristics of an industry
or market, some are more important than others.
Internal economies of scale (IEoS)
Internal economies of scale come from the long term growth of the firm itself. Examples include:
1. Technical economies of scale: (these relate to aspects of the production process itself):
a. Expensive capital inputs: Large-scale businesses can afford to invest in specialist
capital machinery. For example, a supermarket might invest in database technology
that improves stock control and reduces transportation and distribution costs. Highly
expensive fixed units of capital are common in nearly every mass manufacturing
production process.
b. Specialization of the workforce: Larger firms can split the production processes into
separate tasks to boost productivity. Examples include the use of division of labour
in the mass production of motor vehicles and in manufacturing electronic products.
c. The law of increased dimensions (or the “container principle”) This is linked to the
cubic law where doubling the height and width of a tanker or building leads to a more
than proportionate increase in the cubic capacity – the application of this law opens up
the possibility of scale economies in distribution and freight industries and also in
travel and leisure sectors with the emergence of super-cruisers such as P&O‘s
Ventura. Consider the new generation of super-tankers and the development of
enormous passenger aircraft such as the Airbus 280 which is capable of carrying well
over 500 passengers on long haul flights. The law of increased dimensions is also
important in the energy sectors and in industries such as office rental and
warehousing. Amazon UK for example has invested in several huge warehouses at its
central distribution points – capable of storing hundreds of thousands of items.
d. Learning by doing: There is growing evidence that industries learn-by-doing! The
average costs of production decline in real terms as a result of production experience
as businesses cut waste and find the most productive means of producing output on a
bigger scale. Evidence across a wide range of industries into so-called ―progress
ratios‖, or ―experience curves‖ or ―learning curve effects‖, indicate that unit
manufacturing costs typically fall by between 70% and 90% with each doubling of
cumulative output. Businesses that expand their scale can achieve significant
learning economies of scale.

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2. Monopsony power: A large firm can purchase its factor inputs in bulk at discounted prices
if it has monopsony (buying) power. A good example would be the ability of the electricity
generators to negotiate lower prices when finalizing coal and gas supply contracts. The
national food retailers have monopsony power when purchasing their supplies from farmers
and wine growers and in completing supply contracts from food processing businesses. Other
controversial examples of the use of monopsony power include the prices paid by coffee
roasters and other middle men to coffee producers in some of the poorest parts of the world.
3. Managerial economies of scale: This is a form of division of labour where firms can
employ specialists to supervise production systems. Better management; increased
investment in human resources and the use of specialist equipment, such as networked
computers can improve communication, raise productivity and thereby reduce unit costs.
4. Financial economies of scale: Larger firms are usually rated by the financial markets to be
more „credit worthy‟ and have access to credit with favourable rates of borrowing. In
contrast, smaller firms often pay higher rates of interest on overdrafts and loans. Businesses
quoted on the stock market can normally raise new financial capital more cheaply through the
sale of equities to the capital market.
5. Network economies of scale: (Please note: This type of economy of scale is linked more to
the growth of demand for a product – but it is still worth understanding and applying.) There is
growing interest in the concept of a network economy. Some networks and services have
huge potential for economies of scale. That is, as they are more widely used (or adopted),
they become more valuable to the business that provides them. We can identify networks
economies in areas such as online auctions and air transport networks. The marginal
cost of adding one more user to the network is close to zero, but the resulting financial
benefits may be huge because each new user to the network can then interact, trade with all
of the existing members or parts of the network. The rapid expansion of e-commerce is a
great example of the exploitation of network economies of scale. EBay is a classic example of
exploiting network economies of scale as part of its operations.
Cost
(Per unit of output)
LRAC1
B
Economies of Scale
LRAC2
Learning
economies
C
A
Output

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The container principle at work!
Economies of scale – the effects on price, output and profits for a profit maximizing firm
Scale economies allow a supplier to move from SRAC1 to SRAC2. A profit maximising producer will
produce at a higher output (Q2) and charge a lower price (P2) as a result – but the total abnormal
profit is also much higher (compare the two shaded regions).
Both consumer and producer surplus (welfare) has increased – there has been an improvement in
economic welfare and economic efficiency – the key is whether cost savings are passed onto
consumers!
External economies of scale (EEoS)
External economies of scale occur outside of a firm but within an industry. For example
investment in a better transportation network servicing an industry will resulting in a decrease in
Costs
Output (Q)
SRAC1
SRAC2
AR
(Demand)
MR
MC1
MC2
P1
P2
Q1 Q2
Profit at Price P1
Profit at Price P2

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costs for a company working within that industry, thus external economies of scale have been
achieved. Another example is the development of research and development facilities in local
universities that several businesses in an area can benefit from. Likewise, the relocation of
component suppliers and other support businesses close to the centre of manufacturing are also
an external cost saving.
Agglomeration economies may also result resulting from the clustering of similar businesses in a
distinct geographical location be it software businesses in Silicon Valley or investment banks in the
City of London.
Economies of Scale – The Importance of Market Demand
The market structure of an industry is affected by the extent of economies of scale available to
individual suppliers and by the total size of market demand. In many industries, it is possible for
smaller firms to make a profit because the cost disadvantages they face are relatively small. Or
because product differentiation allows a business to charge a price premium to consumers which
more than covers their higher costs.
A good example is the retail market for furniture. The industry has some major players in each of its
different segments (e.g. flat-pack and designer furniture) including the Swedish giant IKEA. However,
much of the market is taken by smaller-scale suppliers with consumers willing to pay higher prices for
bespoke furniture owing to the low price elasticity of demand for high-quality, hand crafted furniture
products. Small-scale manufacturers can therefore extract the consumer surplus that is present
when demand is estimated to have a low elasticity of demand.
Economies of Scope
These are different from economies of scale! Economies of scope occur where it is cheaper to
produce a range of products rather than specialize in just a handful of products. And they can be
exploited when a business owns a resource that can be used more than once in different ways!
For example, in the increasingly competitive world of postal services and business logistics, the main
service providers such as Royal Mail, UK Mail, Deutsche Post and the international parcel carriers
including TNT, UPS, and FedEx are broadening the range of their services and making more better
use of their existing collection, sorting and distribution networks to reduce costs and earn higher
profits from higher-profit-margin and fast growing markets.
A company‘s management structure, administration systems and marketing departments are
capable of carrying out these functions for more than one product.
Expanding the product range to exploit the value of existing brands is a good way of exploiting
economies of scope. Perhaps a good example of ―brand extension‖ is the Easy Group under the
control of Stelios where the distinctive Easy Group business model has been applied (with varying
degrees of success) to a wide range of markets – easy Pizza, easy Cinema, easy Car rental, easy
Bus and easy Hotel to name just a handful! Procter and Gamble is the largest consumer household
products maker in the world. Its brands include Crest, Duracell, Gillette, Pantene, and Tide, to name
just a few. Twenty four of its brands make over $1 billion in sales annually.
Another example of an economy of scope might be a restaurant that has catering facilities and uses
it for multiple occasions – as a coffee shop during the day and as a supper-bar and jazz room in the
evenings. Or a computing business can use its network and databases for many different uses.
Case Study: Investment in Sports Grounds
Hotels are a hot topic at sports venues. The owners of these venues are looking for ways to make
better return on their assets. The solution is to explore new business opportunities, invest in
extensive modernisation and spend cash on large-scale redevelopment schemes.

19
Capacity utilisation is an important challenge facing a sporting venue. There are only so many
cricket matches, grand prix races or rugby games that draw spectators.
By adding purpose-built conference, banqueting and leisure facilities, sports venues can tap into a
different customer base. A hotel facility can attract demand from businesses looking for corporate
hospitality and conferences. Having a hotel also allows a venue to access consumer spending on
short breaks – one of the fastest growing segments of the leisure industry. Most of the planned
hotels will be branded (e.g. Holiday Inn, Marriott) which allows the venue to benefit from a trusted
hotel name and gets access to established distribution channels.
Source: Business Cafe
Minimum Efficient Scale (MES)
The minimum efficient scale (MES) is the scale of production where the internal economies of
scale have been fully exploited. The MES corresponds to the lowest point on the long run
average cost curve and is also known as an output range over which a business achieves
productive efficiency.
The MES is not a single output level – more likely we describe the minimum efficient scale as
comprising a range of outputs where the firm achieves constant returns to scale and has reached
the lowest feasible cost per unit.
The MES depends on the nature of costs of production in a specific sector or industry.
1. In industries where the ratio of fixed to variable costs is high, there is plenty of scope for
reducing unit cost by increasing the scale of output. This is likely to result in a concentrated
market structure (e.g. an oligopoly, a duopoly or a monopoly) – indeed economies of scale
may act as a barrier to entry because existing firms have achieved cost advantages and
they then can force prices down in the event of new businesses coming in!
2. In contrast, there might be only limited opportunities for scale economies such that the MES
turns out to be a small % of market demand. It is likely that the market will be competitive
with many suppliers able to achieve the MES. An example might be a large number of hotels
in a city centre or a cluster of restaurants in a town. Much depends on how we define the
market!
Costs
Revenues
Output (Q)MES Q2
LRAC
Increasing return to scale – economies of
scale - falling LRAC
Decreasing returns –
diseconomies of scale

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3. With a natural monopoly, the long run average cost curve continues to fall over a huge
range of output, suggesting that there may be room for perhaps one or two suppliers to fully
exploit all of the available economies of scale when meeting market demand.
Diseconomies of scale
Diseconomies are the result of decreasing returns to scale.
The potential diseconomies of scale a firm may experience relate to:
1. Control – monitoring the productivity and the quality of output from thousands of employees
in big corporations is imperfect and costly – this links to the concept of the principal-agent
problem – how best can managers assess the performance of their workforce when each of
the stakeholders may have a different objective or motivation which can lead to stakeholder
conflict?
2. Co-ordination - it can be difficult to co-ordinate complicated production processes across
several plants in different locations and countries. Achieving efficient flows of information in
large businesses is expensive as is the cost of managing supply contracts with hundreds of
suppliers at different points of an industry‘s supply chain.
3. Co-operation - workers in large firms may develop a sense of alienation and loss of morale.
If they do not consider themselves to be an integral part of the business, their productivity
may fall leading to wastage of factor inputs and higher costs. Traditionally this has been seen
as a problem experienced by the larger state sector businesses, examples being the Royal
Mail and the Firefighters, the result being a poor and costly industrial relations performance.
However, the problem is not concentrated solely in such industries. A good recent example of
a bitter industrial relations dispute was between Gate Gourmet and its workers.
Avoiding diseconomies of scale
A number of economists are skeptical about diseconomies of scale. They believe that proper
management techniques and appropriate incentives can do much to reduce the risk of industrial
strife. Here are three of the reasons to doubt the persistence of diseconomies of scale:
1. Developments in human resource management (HRM). HRM is a horrible phrase to
describe improvements that a business might make to procedures involving worker
recruitment, training, promotion, retention and support of faculty and staff. This becomes
critical to a business when the skilled workers it needs are in short supply. Recruitment and
retention of the most productive and effective employees makes a sizeable difference to
corporate performance in the long run.
2. Performance related pay schemes (PRP) can provide financial incentives for the workforce
leading to an improvement in industrial relations and higher productivity. Another aim of PRP
is for businesses to reward and hang onto their most efficient workers. The John Lewis
Partnership is often cited as an example of how a business can empower its employees by
giving them a stake in the financial success of the organization.
3. Increasingly companies are engaging in out-sourcing of manufacturing and distribution as
they seek to supply to ever-distant markets. Out-sourcing is a tried and tested way of reducing
costs whilst retaining control over production although there may be a price to pay in terms of
the impact on the job security of workers whose functions might be outsourced overseas.
Case Study: Amazon – Economies of Scale and Scope

21
Increased dimensions: Firstly, the company invested in enormous warehouses to stock its inventory
of books, DVDs, computer peripherals. This allows it to benefit from the law of increased dimension.
Buying power: Amazon has significant monopsony power when it purchases books directly from
publishers, thereby bypassing its reliance on wholesalers and giving it a higher profit margin.
Learning by doing and first-mover advantage: Amazon is benefiting from learning by doing having
been one of the first major players in the online retail sector. The unit costs of production tend to
decline in real terms as a result of production experience as businesses cut waste and find the most
productive means of producing output on a bigger scale
Pre-Orders - Amazon use a pre-order system for customers which allows it to capture early demand
and improve stock (or inventory) forecasting.
Less invested capital: As an online retailer, Amazon avoids the need for retail stores – one
advantage is that it has lower invested capital in the business and it frees up resources for customer
fulfillment and investment in new technology – Amazon distributes to over 200 countries.
Shifting stock at speed: Amazon has a much faster stock velocity – measured by the number of
weeks an item remains in stock. For Amazon this is half that of a physical store – and the benefit is a
reduction in obsolescence loss (the value of unsold stock is estimated to decline by 30% per year)
Economies of scale help to give Amazon a significant cost advantage. The business is also looking
to create economies of scope from marketing and broadening the range of products available
through the Amazon brand. Among the innovative business ideas under development we can
identify:
Merchants@/Marketplace which gives independent (third party) sellers the opportunity to sell
their products through the Amazon platform
Amazon Enterprise Solutions – where Amazon provides e-commerce technology for a range
of partners such as Marks and Spencer, Lacoste, Mothercare and Timex
CreateSpace – a new self-publishing platform for books, music and video
Amazon Kindle – a portable reader that wirelessly downloads books, blogs, magazines and
newspapers to a high-resolution electronic paper display that looks and reads like real paper,
Amazon now sells nearly one fifth of the books bought in the UK each year.
Suggestions for further reading on economies of scale and scope

22
Consoles look to hit their stride (BBC news, July 2008)
Cost headache for games developers (BBC news, December 2007)
Economies of scale in printing (Tutor2u economics blog, March 2008)
GM installs world's biggest rooftop solar panels (Guardian, July 2008)
How world's biggest ship is delivering our Christmas - all the way from China (Guardian)
Mobile web reaches critical mass (BBC news, July 2008)
Salad production on a massive scale (BBC news, June 2008)

23
4. Business Revenues
Revenue (or turnover) is the income generated from the sale of output in product markets.
o Average Revenue (AR) = Price per unit = total revenue / output
o Marginal Revenue (MR) = the change in revenue from selling one extra unit of output
The table below shows the demand for a product where there is a downward sloping demand curve.
Price per unit
(average revenue)
Quantity Demanded
(Qd)
Total Revenue
(TR) (PxQ)
Marginal Revenue
(MR)
£s units £s £s
400 220 88000
370 340 125800 315
340 460 156400 255
310 580 179800 195
280 700 196000 135
250 820 205000 75
220 940 206800 15
190 1060 201400 -45
Average and Marginal Revenue
In our example in the table above, as price per unit falls, demand expands and total revenue rises
although because average revenue falls as more units are sold, this causes marginal revenue to
decline. Eventually marginal revenue becomes negative, a further fall in price (e.g. from £220 to
£190) causes total revenue to fall.
Because the price per unit is declining, total revenue is rising at a decreasing rate and will eventually
reach a maximum (see the next paragraph).
Elasticity of Demand and Total Revenue
When a firm faces a perfectly elastic demand curve, then average revenue = marginal revenue (i.e.
extra units of output can all be sold at the ruling market price).
However, most businesses face a downward sloping demand curve! And because the price per unit
must be cut to sell extra units, therefore MR lies below AR. In fact he MR curve will fall at twice the
rate of the AR curve. You don’t have to prove this for the exams – but it is worth remembering that
the marginal revenue curve has twice the slope of the AR curve!
Maximum total revenue occurs where marginal revenue is zero: no more revenue can be achieved
from producing an extra unit of output. This point is directly underneath the mid-point of a linear
demand curve.

24
Total revenue is shown by the area underneath the firm‘s demand curve (average revenue curve).
Suggestions for further reading on business revenues
Carmakers tackle profit problems (BBC news, July 2008)
Costs
Output (Q)
Average revenue AR
Marginal revenue MRQ1
P1
Total revenue at price P1 where marginal
revenue is zero
A rise in price to P2 causes a reduction in total
revenue
P2
Q2
Total revenue at price P2
Total revenue (TR) refers to the amount of money received by a firm from selling a given
level of output and is found by multiplying price (P) by output ie number of units sold
Output (Q)
Revenue
Total Revenue
(TR)
Marginal Revenue
(MR)
Average Revenue
(Demand) AR
Total revenue is
maximised when
MR = 0
Price elasticity of
demand = 1 at this
output
Ped >1 for a price
fall along this
length of AR

25
Revenue fears hit Vodafone shares (BBC news, July 2008)
Price elasticity of demand and total revenue (Bryn Jones Online, You Tube video)

26
5. Profits
The Nature of Profit
Profit measures the return to risk when committing scarce resources to a market or industry.
Entrepreneurs take risks for which they require an adequate expected rate of return. The higher
the market risk and the longer they expect to have to wait to earn a positive return, the greater will be
the minimum required return that an entrepreneur is likely to demand.
1. Normal profit - is the minimum level of profit required to keep factors of production in their
current use in the long run. Normal profits reflect the opportunity cost of using funds to
finance a business. If you decide to put £200,000 of your personal savings into a new business,
those funds could have earned a low-risk rate of return by being saved in a bank or building
society deposit account. You might therefore use the rate of interest on that £200,000 as the
minimum rate of return that you need to make from your investment in order to keep going in the
long run!
Of course we are ignoring here differences in risk and also the non-financial benefits of running and
building your own business or investing funds in someone else‘s project.
Because we treat normal profit as an opportunity cost of investing financial capital in a business,
we normally include an estimate for normal profit in the average total cost curve, thus, if the firm
covers its ATC (where AR meets AC) then it is making normal profits.
2. Sub-normal profit - is any profit less than normal profit (where price < average total cost)
3. Abnormal profit - is any profit achieved in excess of normal profit - also known as
supernormal profit. A firm earns supernormal profit when its profit is above that required to keep
its resources in their present use in the long run. When firms are making abnormal profits, there is
an incentive for other producers to enter a market to try to acquire some of this profit. Abnormal
profit persists in the long run in imperfectly competitive markets such as oligopoly and
monopoly where firms can successfully block the entry of new firms. We will come to this later
when we consider barriers to entry in monopoly.
Case Study: Sub-normal profits drive mortgage lenders out of the market – for now
What is happening in the UK mortgage market? Rarely a day goes by without news of another
mortgage lender reassessing the risk of their housing loans and deciding to pull the plug on some of
their mortgage products. Following on from the Northern Rock which has virtually stopped lending at
all and wants to shift a sizeable portion of its mortgage book onto others, the Co-operative Bank,
Lehman Brothers and First Direct have all announced that they are withdrawing two-year fixed rate
mortgage products for the time being.
All of this is one of the direct results of the credit crunch. The lenders are spinning this as a way of
providing better service-levels to their existing customers but the reality is that the supply of finance
in the wholesale money markets has been badly squeezed and this is now feeding through to the
retail market for housing loans. It is costing the mortgage lenders more to borrow funds and their
profit margins have been squeezed to a level where sub-normal profits are being made. Little wonder
that some of the major players are effectively exiting the market by withdrawing some mortgage
products from sale. Only when conditions improve will they consider a return.
Source: Tutor2u Economics Blog, April 2008
Calculating economic profit
Consider the following example:

27
The table shows data for an owner-managed firm for a particular year.
Total revenue £320,000
Raw material costs £30,000
Wages and salaries £85,000
Interest paid on bank loan £30,000
Salary that the owner could have earned elsewhere £32,000
Interest forgone on owner's capital invested in the business £20,000
In a simple accounting sense, the business has total revenue of £320,000 and costs of £145,000
giving an accounting profit of £175,000. But the firm‘s profit according to an economist should take
into account the opportunity cost of the capital invested in the business and the income that the
owner could have earned elsewhere. Taking these two items into account we find that the economic
profit is £123,000.
Profit maximisation
Profits are maximised when marginal revenue = marginal cost
Price Per Unit
(£)
Demand /
Output
(units)
Total
Revenue
(£)
Marginal
Revenue
(£)
Total
Cost
(£)
Marginal
Cost
(£)
Profit
(£)
50 33 1650 2000 -350
48 39 1872 37 2120 20 -248
46 45 2070 33 2222 17 -152
44 51 2244 29 2312 15 -68
42 57 2394 25 2384 12 10
40 63 2520 21 2444 10 76
38 69 2622 17 2480 6 142
36 75 2700 13 2534 9 166
34 81 2754 9 2612 13 142
Consider the example in the table above. As price per unit (average revenue) declines, so demand
expands. Total revenue rises but at a decreasing rate (as shown by column 4 – marginal revenue).
Initially the firm is making a loss because total cost exceeds total revenue. The firm moves into profit
at an output level of 57 units. Thereafter profit is increasing because the marginal revenue from
selling units is greater than the marginal cost of producing them. Consider the rise in output from 69
to 75 units. The MR is £13 per unit, whereas marginal cost is £9 per unit. Profits increase from £142
to £166.
But once marginal cost is greater than marginal revenue, total profits are falling. Indeed the
firm makes a loss if it increases output to 93 units.

28
As long as marginal revenue is greater than marginal cost, total profits will be increasing (or losses
decreasing). The profit maximisation output occurs when marginal revenue = marginal cost.
In the next diagram we introduce average revenue and average cost curves into the diagram so that,
having found the profit maximising output (where MR=MC), we can then find (i) the profit maximising
price (using the demand curve) and then (ii) the cost per unit.
The difference between price and average cost marks the profit margin per unit of output.
Total profit is shown by the shaded area and equals the profit margin multiplied by output
The short run supply decision - the shut-down point
The theory of the firm assumes that a business needs to make at least normal profit in the long run to
justify remaining in an industry but this is not a strict requirement when the firm will continue to
produce as long as total revenue covers total variable costs or put another way, so long as price per
Costs
Revenue
Output (Q)
SRAC
AR
(Demand)
MR
SRMC
Q1
P1
AC1
Supernormal profits at
Price P1 and output Q1
AC2
Q2
Normal profit at Q2 where
AR = AC
Profits are
decreasing when
MR < MC
Marginal Revenue
Marginal Cost
Q1
Revenue
And Cost
Output (Q)
Profits are
increasing when
MR > MC

29
unit > or equal to average variable cost (AR = AVC). This is sometimes referred to as the shut-
down price.
The reason for this is as follows. A business‘s fixed costs must be paid regardless of the level of
output. If we make an assumption that these costs are sunk costs (i.e. they cannot be recovered if
the firm shuts down) then the loss per unit would be greater if the firm were to shut down, provided
variable costs are covered.
Consider the cost and revenue curves facing a business in the short run in the diagram above.
 Average revenue (AR) and marginal revenue curves (MR) lies below average cost across the
full range of output, so whatever output produced, the business faces making a loss.
 At P1 and Q1 (where marginal revenue equals marginal cost), the firm would shut down as
price is less than AVC. The loss per unit of producing is vertical distance AC.
 If the firm shuts down production the loss per unit will equal the fixed cost per unit AB.
 In the short-run, provided that the price is greater than or equal to P2, the business can justify
continuing to produce in the short run.
Northern Foods decides to mothball a factory
Northern Foods, which supplies Marks and Spencer, is to mothball a factory making ready-meals
because it is no longer economical. They said that, whilst the plant had been profitable in recent
years it was no longer generating enough money to give an adequate return to shareholders. Some
analysts have argued that the decision might be due to the effects of the monopsony power of Marks
and Spencer which has demanded discounts of up to 6% from its top suppliers including Northern
Foods.
Source: Adapted from news reports, May 2008
Deriving the Firm‟s Supply Curve in the Short Run
In the short run, the supply curve for a business operating in a competitive market is the
marginal cost curve above average variable cost.
Costs,
Revenues
Output (Q)Q1
MC
AVC
AR
MR
P1
AC1
A
B
C
P1 is below average variable cost
P2
ATC

30
In the long run, a firm must make a normal profit, so when price = average total cost, this is
the break-even point. It will therefore shut down at any price below this in the long run.
As a result the long run supply curve will be the marginal cost curve above average total
cost.
The concept of a ‗supply curve‘ is inappropriate when dealing with monopoly because a monopoly is
a price-maker, not a ―passive‖ price-taker, and can thus select the price and output combination on
the demand curve so as to maximise profits where marginal revenue = marginal cost.
Changes in demand and the profit maximising price and output
A change in demand and/or production costs will lead to a change in the profit maximising price and
output. In exams you may often be asked to analyse how changes in demand and costs affect the
equilibrium output for a business. Make sure that you are confident in drawing these diagrams and
you can produce them quickly and accurately under exam conditions.
In the diagram below we see the effects of an outward shift of demand from AR1 to AR2 (assuming
that short run costs of production remain unchanged). The increase in demand causes a rise in the
market price from P1 to P2 (consumers are now willing and able to buy more at a given price
perhaps because of a rise in their real incomes or a fall in interest rates which has increased their
purchasing power) and an expansion of supply (the shift in AR and MR is a signal to firms to move
along their marginal cost curve and raise output). Total profits have increased.
Costs
Output (Q)
AC
AR1
(Demand)
MR1
MC
Q1
P1
AC1
Profit Max at Price P1
P2
AC2
Q2
AR2
MR2
A rise in demand (a shift in AR and MR) causes an expansion of supply, a higher profit maximising
price and an increase in supernormal profits

31
Wiseman dairies hit by profits blow
Shares in Robert Wiseman, Scotland‘s biggest milk supplier, have taken a hit following news of lower
profits. Operating profits were reported as falling by 16% after a £6.1m fine levied by the Office for
Fair Trading for alleged price fixing. The company is also suffering from the effects of higher energy,
packaging and distribution costs caused by the rising world price of oil. A third factor is a slump in
the market price of cream. The company has found that it cannot always pass on higher input prices
to customers, partly because of pre-existing milk delivery contracts with some of the major
supermarkets.
Source: Adapted from news reports, May 2008
The Functions of Profit in a Market Economy
Profits serve a variety of purposes to businesses in a market-based economic system
1. Finance for investment Retained profits are source of finance for companies undertaking
investment projects. The alternatives such as issuing new shares (equity) or bonds may not
be attractive depending on the state of the financial markets especially in the aftermath of the
credit crunch.
2. Market entry: Rising profits send signals to other producers within a market. When the
existing firms are earning supernormal profits, this signals that profitable entry may be
possible. In contestable markets, we would see a rise in market supply and lower prices. But
in a monopoly, the dominant firm(s) may be able to protect their position through barriers to
entry.
3. Demand for factor resources: Scarce factor resources tend to flow where the expected rate
of return or profit is highest. In an industry where demand is strong more land, labour and
capital are then committed to that sector. Equally in a recession, national output, employment,
incomes and investment all fall leading to a squeeze on profit margins and attempts by
businesses large and small to cut costs and preserve their market position. In a flexible labour
market, a fall in demand can quickly lead to a reduction in investment and cut-backs in labour
demand.
4. Signals about the health of the economy: The profits made by businesses throughout the
economy provide important signals about the health of the macroeconomy. Rising profits
might reflect improvements in supply-side performance (e.g. higher productivity or lower costs
through innovation). Strong profits are also the result of high levels of demand from domestic
and overseas markets. In contrast, a string of profit warnings from businesses could be a lead
indicator of a macroeconomic downturn.

32
Net percentage rate of return on capital employed, seasonally adjusted
Net Profit for Manufacturing and Service Businesses
Source: Reuters EcoWin
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
18.0
20.0
22.0
Rateofreturn(%)
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
18.0
20.0
22.0
Manufacturing
Services
Steps to higher profits
In an ideal world, running a business would be easy! You come up with an innovative idea, create a
new product or service so popular you can‘t stop people from buying it. Word spreads and, before
you know it, sales and profits are growing. In reality, few businesses are able to sit back and watch
the profits roll in. Creating and increasing profitability depends on doing a hundred little things better
than the existing competition. So what are the best ways for a business to increase its profitability?
Method 1: Grow the “Top Line”
Every business and every market is different. But for most businesses, the best long-term way to
improve profitability is to increase sales (also known as ―turnover‖). This is for four main reasons:
1. If a business has a high gross profit margin, every extra sale is profitable. Once your
turnover reaches the break-even level then each additional sale adds to profits.
2. Acquiring new customers is made easier by greater market presence and reputation. As
you grow, unit costs are reduced through economies of scale.
3. If your customers tend to be loyal, the value of each new customer lays not just in the
immediate sale, but in future sales as well. The cost of selling to existing customers is
always lower than the cost of acquiring new customers.
4. Defending a market share against competitors is easier than defending high profit margins.

33
Many businesses operate in what are called “low growth” markets - where expansion only comes
by taking a bigger share of the available demand. Low growth markets tend to be in markets where
income elasticity of demand is low, so that as the real incomes of consumers increase, there is
little positive effect on market demand.
Method 2: Keep Costs under Control
If a business has a low gross profit margin, reducing direct costs increases the profit on each sale.
Eliminating overheads has an immediate impact on profit. Every business can increase profitability by
reducing hidden costs. Hidden costs include the costs of employing inappropriate people since poor
recruitment can lead to lower quality, increased training costs and ultimately redundancy costs.
Suggestions for further reading on profits
A selection of recent news articles on the profitability of businesses in different markets and
industries and how changes in demand and costs affect prices and profits.
Dominos delivers stronger profits (BBC news, July 2008)
Fuel costs eat into Fedex profit (BBC news, March 2008)
Grand Theft Auto IV set to break all records (BBC news, April 2008)
Gregg‘s warns of increased costs (BBC news, March 2008)
Higher oil prices see BP‘s profits surge (Guardian, July 2008)
Pubs close as beer sales fall (BBC news, July 2008)
Ryanair slashes fares to boost demand and fill airline capacity (Guardian, August 2008)
Should the British pub get a government subsidy? (BBC news, July 2008)
Silverjet calls in administrators (BBC news, June 2008)
Supporters count the cost of following a Premiership footie club (Tutor2u blog, March 2008)
Weak dollar boosts Nike profits (BBC news, March 2008)
Wolseley hit by housing slowdown (BBC news, July 2008)

34
6. What Objectives Do Firms Have?
In this chapter we consider a range of different
business objectives – much depends on the
ownership and control of a business and the type of
market in which it operates.
Profit maximisation
The traditional theory of the firm tends to assume that
businesses possess sufficient information, market
power and motivation to set prices or their products
that maximise profits. This assumption is now
criticised by economists who have studied the
organisation and objectives of modern-day
corporations.
Why might a business depart from profit maximisation?
There are numerous possible explanations. Some relate o the lack of accurate information
required to undertake profit maximising behaviour. Others concentrate on the alternative objectives
of businesses. We start first with the effects of imperfect information.
It might be hard for a business to pinpoint precisely their profit maximising output, as they cannot
accurately calculate marginal revenue and marginal costs. Often the day-to-day pricing decisions of
businesses are taken on the basis of ―estimated demand conditions.‖
Secondly, most modern businesses are multi-product firms operating in a range of separate
markets across countries and continents – as a result the volume of information that they have to
handle can be vast. And they must keep track of the ever-changing preferences of consumers. The
idea that there is a neat, single profit maximising price is redundant.
Behavioural Theories of the Firm
Behavioural economists believe that modern corporations are complex organizations made up
various stakeholders. Stakeholders are defined as any groups who have a vested interest in the
activity of a business. Examples might include:
o Employees within a business
o Managers employed by the firm
o Shareholders – people who have an equity stake in a business
o Customers in the market
o The local community
o The government and it‘s agencies including local government
Each of these groups is likely to have different objectives or goals at points in time. The dominant
group at any moment can give greater emphasis to their own objectives – for example price and

35
output decisions may be taken at local level by managers – with shareholders taking only a distant
and imperfectly informed view of the company‘s performance and strategy.
If firms are likely to move away from pure profit maximising behaviour, what are the alternatives?
1. Satisficing behaviour involves the owners setting minimum acceptable levels of
achievement in terms of business revenue and profit.
2. Sales Revenue Maximisation
The objective of maximising sales revenue rather than profits was initially developed by the work of
William Baumol (1959). His research focused on the behaviour of manager-controlled businesses.
Baumol argued that annual salaries and other perks might be closely correlated with total sales
revenue rather than profits. Companies geared towards maximising revenue are likely to make
frequent and extensive use of price discrimination (or yield management) as a means of extracting
extra revenue and profit from consumers.
3. Managerial Satisfaction model
An alternative view was put forward by Oliver Williamson (1981), who developed the concept of
managerial satisfaction (or managerial utility). This can be enhanced by raising sales revenue.
Price and output differs if the firm changes its objective from profit to revenue maximisation.
Assuming that the firm‘s costs remain the same, a firm will choose a lower price and supply a higher
output when sales revenue maximisation is the main objective.
The profit maximising price is P2 at output Q2 whilst the revenue maximising price is P1 at output
Q1.
A change in the objectives of the business has an effect on welfare and in particular the balance
between consumer and producer surplus. Consumer surplus is higher with sales revenue
maximisation because output is higher and price is lower.
Costs
Output (Q)
AC
AR (Demand)
MR
MC
Q1
P1
AC1
P2
AC2
Q2
Revenue Max at Price P2

36
Cadbury abandons its profit target
Cadbury Schweppes Plc, the manufacturer of Dairy Milk chocolate has decided to scrap its
profitability target in the wake of a sharp increase in the costs of their raw materials. Three years ago
Cadbury announced targets for annual improvements in profit margins ranging from 0.5 to 0.75%.
But the rising price of oil-based raw materials and the world market price of cocoa and sugar have
conspired to make meeting this target impossible. Prospects for profits have also been adversely
affected by the hot summer which has hit demand for chocolate and the unplanned recall of several
high profile products because of fears of salmonella poisoning. The business is a major global
presence in the confectionery market with an estimated ten per cent world market share. In June
2007, Cadbury announced that it planned to cut its workforce by 15%. The reorganisation will cost
Cadbury about £450m in a one-off charge.
Adapted from Tutor2u blog, November 2006 and news reports, June 2007
Social Entrepreneurs – “not just for profit” businesses
Underneath the surface of an economy dominated by corporate giants, a new breed of business is
flourishing, where profit is not always the bottom line; these are entrepreneurs operating for a social
purpose and not just for profit. A social enterprise is a business that has social objectives whose
surpluses are reinvested for that purpose in the business or the community, rather than being driven
by the need to seek profit to satisfy investors. Rather than maximise shareholder value and distribute
dividends, a social enterprise is looking to achieve social and environmental aims over the long term.
Examples include
o Café Direct
o Fair Trade
o Traidcraft
o Divine Chocolate
o The Eden Project
o Fifteen Foundation (Jamie Oliver)
o Housing Associations
o Micro-credit developed by the
Grameen Bank and its founder, the
Nobel-Prize winner Muhammad Yu
Social Entrepreneurship
An example from India
Devi Prasad Shetty strives to make sophisticated health care in India available to all irrespective of
their economic situation or geographic location. He founded the Narayana Hrudayalaya Hospital in
Bangalore in 2001 and co-founded the Asia Heart Foundation. In addition, Shetty has built a
network of 39 telemedicine centres to reach out to patients in remote rural areas. Together, the
network of hospitals performs 32 heart surgeries a day. Almost half the patients are children and
babies. Sixty percent of the treatments are provided below cost or for free.
And one from the UK
The 2008 Independent Social Entrepreneur of the Year award went to Belu Water, a bottled water
company that donates all of its profits to global clean water projects. The company uses carbon-
neutral packaging in the form of a compostable bottle made from corn. Belu is the first carbon-
neutral product being stocked at Tesco. The bottles look like ordinary bottles and can be recycled
with plastics or commercially composted back to soil in just eight weeks. Among its clean water
projects, Belu has installed hand pumps and wells for 20,000 people in India and Mali, and it is
also working on a rubbish-muncher to clean up the Thames. The company has a pledge that each
bottle of mineral water sold will translate as clean water for one person for one month.

37
Source: Adapted from news reports, January 2008
See Young, Gifted and not for Profit (BBC radio 4 In Business) and also the economic impact of
the Eden project. Other good sites include: Schwab Foundation for Social Entrepreneurship
Not for Profit Businesses
These are charities, community organisations that are run on commercial lines e.g. Network Rail:
Network Rail
o Took over the rail network in October 2002
o Stated purpose is to deliver a safe, reliable and efficient railway for Britain.
o It is a company limited by guarantee – whose debts are secured by the government
o Network Rail is a private company operating as a commercial business and regulated by
the Office of Rail Regulation
o Network Rail is a "not-for-dividend" company, which means that all of its profits are invested
in the railway network.
o Train operating companies pay Network Rail for use of the rail infrastructure
Businesses required to main a loss-making service on social grounds
A good example here is the Royal Mail which is required to maintain a universal national postal
delivery service throughout the UK for a uniform price. Household mail makes a loss, cross-
subsidised by business mail – although this market is shrinking for the Royal Mail because of the
introduction of fresh competition from Jan 2006. The Post Office Ltd is a subsidiary of the Royal
Mail Group plc – it runs substantial losses on the network or rural post offices and has been under
great pressure to close hundreds of offices to stem losses.
Suggestions for further reading on business objectives and business ownership
Australian expansion proves a move too far for Starbucks (Tutor2u blog, July 2008)
Founder of bottled water company honoured for work in Third World (Independent, Jan 2008)
How business embraced charity (The Observer, June 2008)
Making profit with a conscience (BBC news, March 2008)
Motivated by change (Independent, July 2004)
Mysterious death of the petrol station (VVC news, March 2008)
Network Rail announces pre-tax profit of £1.6bn (BBC news, June 2008)
Ryanair flies into the path of an economic storm (Tutor2u blog, July 2008)
Sony predicts TV and game profits (BBC news, June 2008)
Survival challenge for social enterprises (Guardian, July 2008)
Wind farm co-op raises thousands (BBC news, July 2008)

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7. Divorce between Ownership and Control
Ownership and control
The owners of a private sector company normally elect a board of directors to control the
business‘s resources for them. However, when the owner sells shares, or takes out a loan or bond
to raise finance, they may sacrifice some of their control. Other shareholders can exercise their
voting rights, and providers of loans often have some control (security) over the assets of the
business.
This may lead to a degree of conflict between them as these different stakeholders may have
different objectives. The flow chart below attempts to show the divorce between ownership and
control.
The Principal Agent Problem
How do the owners of a large business know that the managers they have employed and who are
making the key day-to-day decisions operate with the aim of maximising shareholder value in both
the short term and the long run?
This lack of information is known as the principal-agent problem or ―agency problem‖. In other
words, one person, the principal, employs an agent (e.g. a sales or finance manager) to perform
tasks on his behalf but he or she cannot ensure that the agent always performs them in precisely
the way the principal would like. The decisions and the performance of the agent are both
impossible and expensive to monitor and the incentives of the agent may differ from those of
the principal. The principal agent problem is illustrated in the flow chart above.
Principals:
Shareholders
Control Mechanisms:
Pressures from the stock market
and from hedge funds and private
investors
Regular meetings with
shareholders (e.g. the AGM)
Scrutiny in the financial press
Performance related pay (to
provide incentives)
Agents:
Board of Directors
Senior Management
OWNERSHIP
CONTROL

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Examples of the principal-agent problem that have hit the headlines recently in the UK include the
mis-management of financial assets on behalf of investors (e.g. the case surrounding Equitable
Life) and the management of companies on behalf of shareholders (e.g. during the turbulent years
experienced by Marks and Spencer and Shell). The classic case in the United States is of course
the Enron fraud and debacle. Follow this BBC news link for more background on the Enron case.
Many investors in a business are 'passive', they might monitor the performance of the corporation
by following the news in the financial press and (occasionally) attending and voting at annual
general meetings but their direct involvement is limited and unlikely to have a bearing on the
crunch decisions of the business. The biggest investors in UK listed companies tend to be large
institutional shareholders such as pension funds and insurance companies.
Incentives Matter! - Employee Share Ownership Schemes
There are various strategies available for coping with the principle- agent problem. One is the rapid
expansion of employee share-ownership schemes and share-options programmes. The
government has encouraged the wider use of share-ownership schemes through a series of tax
incentives. But the use and occasional misuse of share options schemes has been controversial
for several years. A recent example involved the US computer giant Apple.
The growth of "shareholder activism"
Many commentators question the assumption that shareholders play little direct role in influencing
corporate strategy in modern corporations. There are plenty of examples in recent times when both
institutional and individual shareholders have exercised their voting rights to express views on
the direction that a company is taking or its performance. Typically they are critical of a perceived
failure of a business to maximise shareholder value measured in terms of share price, the flow of
dividend incomes etc.
Increasingly we are seeing a new breed of shareholders who are seen to be much more proactive
in putting executive management under pressure - these are known as activist shareholders. At
the forefront of this change has been the expansion of private hedge funds and a number of high
profile and very wealthy private investors. Latterly, the sovereign wealth funds have appeared on
the scene.
An activist shareholder uses an equity stake in a corporation to put pressure on its existing
management. The goals of activist shareholders range from financial (increase of shareholder
value through changes in dividend decisions, plans for cost cutting or capital investment projects
etc.) to non-financial (dis-investment from particular countries with a poor human rights record, or
pressuring a business to speed up the adoption of environmentally friendly policies and build a
better reputation for ethical behaviour, etc.).
Activist shareholders do not have to hold large stakes in a business to make an impact. Even those
with relatively small stakes or 3 or 4 per cent can launch publicity campaigns and make direct
contact with the senior management. Private equity / hedge funds have been among those most
involved in the rise of shareholder activism. They tend to focus on under-performing businesses
Is this new breed of shareholder activists an important voice and counter-balance to the power of
entrenched management and willing to stand up to corporate corruption and highlight poor
management? Can they help to overcome the principle-agent problem? Or are they merely
aggressive corporate raiders seeking short-term corporate change merely for their own personal
gain?

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Environmental groups such as Friends of the Earth have also latched onto the potential for
shareholder activism to impact on businesses especially in the areas of the environmental impact
of their business activities.
That said it remains the case that the pattern of ownership and control within British industry is
dispersed. Typically the largest shareholder in any large business listed on the stock market is
likely to own a minority of the shares. Majority ownership by a single shareholder is unusual.
Examples of recent shareholder activism
Sainsbury's: In 2004, a third of J Sainsbury's shareholders voted against the
supermarket's pay policy, objecting to its decision to give a £2.3m bonus to ousted
chairman Sir Peter Davis. Sainsbury's subsequently decided to cancel the controversial pay
award. Sir Peter Davis quit Sainsbury's after a group of major institutional shareholders
demanded management changes. He was replaced by Justin King.
Disney: In 2004, Michael Eisner, the chairman and chief executive of Disney, resigned
after 43% of Disney shareholders voted against his re-election.
EuroTunnel: In 2004, the management board of Euro Tunnel was ousted at the company's
AGM.
Vodafone: In May of 2006, Vodafone announced the biggest loss in British corporate
history (£14.9 billion). In July 2006, the CEO of Vodafone Arun Sarin came under huge
pressure from a group of shareholders unhappy about the performance of the struggling
telecoms company. In the event, shareholders voted 86% in favour of Mr Sarin, with 9.5%
voting against, and 4.5% abstaining.
Daimler-Chrysler: In April 2007, about 9,000 shareholders attended the German-US
carmaker's annual meeting and voiced strong criticisms of the businesses‘ performance.
Many shareholders stood up during the meeting to condemn the transatlantic merger which
took place between Daimler-Benz and Chrysler in 1998.
Motorola versus Carl Icahn: The financier Carl Icahn has a reputation as one of the
leading shareholder activists. He has been in a battle with Motorola over their strategy.
Photo-Me: In October 2007 the chairman and chief executive of the passport booth
operator Photo-Me agreed to quit in the face of growing opposition
More reading on shareholder activism:
Hail shareholder! (The Economist May 2007)
Owner-drivers (The Economist, May 2007)
Corporate Social Responsibility and Business Ethics
Business ethics is concerned with the social responsibility of management towards the firm‘s
stakeholders, the environment and society in general. There is a growing belief that ethical and
‗green‘ business are linked to improved business performance because of increased public
concern for human rights and the environment. Many businesses are now trumpeting their
progress in making their activities carbon neutral by offsetting the impact of their production
activities on their environment through offset activities. Businesses such as Carbon Clear provide a
means by which organisations can find ways to offset their carbon emissions.
Business ethics extends to treating stakeholders ‗fairly‘; hence the growing emphasis on health
and safety issues, good working practices and the like in business decision-making.

41
For more reading on this try this link to the Institute for Business Ethics. The Times 100 Case
Studies includes one on Cadbury‘s and corporate social responsibility. Click here for BBC news
articles on carbon neutrality.
Suggestions for further reading on business ownership and control
Stuart Rose faces shareholder revolt at M&S annual meeting (Guardian, June 2008)
Napster shareholders revolt over iTunes failure (New Zealand Herald, June 2008)
Yell chiefs face investor revolt over big bonuses (The Times, July 2008)

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8. Technological Change, Costs and Supply in the Long-run
What is innovation?
The Oxford English Dictionary defines
innovation as ―making changes to
something established‖. Invention, by
contrast, is the act of ―coming upon or
finding: discovery‖. Innovations frequently
disrupt the way that businesses do things
and may have been doing so for years.
Product innovation is a driving dynamic in
most markets – consider for example how
important innovation is in these markets:
o Telecommunications
o Pharmaceuticals
o Transport
o Audio-visual products
o Markets for low-carbon products
o Farming (important at this time given the global food crisis)
Product innovation is often associated with many small, subtle changes to the characteristics
and performance of a product. Ground-breaking product innovation appears to becoming rarer
despite the billions of dollars spent each year by global pharmaceutical companies and household
goods manufacturers.
New markets and “synergy demand”:
Product innovation creates new markets, especially when new technology creates radically
different products for consumers. Innovation is also a source of synergy demand. For example,
Gillette (a business unit of Proctor and Gamble) launched in 2004 the successor to its top branded
product the Mach3 and Mach3 ―turbo‖ razor. The new ―wet-shave‖ razor is battery powered –
handy given that Gillette also owns the Duracell brand!
Sustaining and disruptive innovations
Many new products are similar to existing ones on the market – companies are often satisfied with
―sustaining innovations” rather than “disruptive innovations” which have the power to upset
the status quo and make serious inroads into the market share of well-established businesses.
Joseph Alois Schumpeter famously made reference to innovation creating ―gales of creative
destruction‖.
Examples of disruptive innovations:
o Emergence of the low-cost airlines following a radically different business model – this has
had a huge effect on national scheduled airline carriers such as British Airways.
o Consider online music download businesses such as iTunes and peer to peer file sharing.
o Voice over Internet Protocol VoIP such as Skype versus traditional telephone and mobile
phone service providers.

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Gains in dynamic efficiency:
Dynamic efficiency occurs over time. It focuses on changes in consumer choice available in a
market together with the quality/performance of goods and services that we buy. Innovation
can stimulate improvements in dynamic efficiency, always providing that the innovations that come
to market are appropriate in satisfying our changing needs and wants
Innovation as a barrier to entry
Innovative behaviour can be an important barrier to entry in markets. Firstly because some the
property rights embedded in product innovations might be protected by patent laws. There is
nearly always a “first mover advantage” for successful innovators that gives them scope to
exploit some monopoly power in a market.
Set against this argument is that view that high rates of innovation reduce barriers to entry because
they challenge existing market power enjoyed by well-established businesses.
Process innovation
Process innovations involve changes to the way in which production takes place, be it on the
factory floor, business logistics or innovative behaviour in managing employees in the workplace.
The effects can be both on a firm‘s cost structure (i.e. the ratio of fixed to variable costs) as well
as the balance of factor inputs used in production (i.e. labour and capital).
Cost reducing innovations cause an outward shift in market supply and they provide the scope
for businesses to enjoy higher profit margins with a given level of demand. Process innovation
should also lead to a more efficient use of resources.
The diagram above uses cost and revenue curves to show the effect of driving down production
costs from SRAC1 to SRAC2 – leading to lower prices and a higher output. You could also use this
diagram to show the gains in producer and consumer surplus that come from cost-reducing
innovation and technological change. Consumers stand to gain from such innovation in that they
should be able to expect lower prices. This increases their real incomes.
Costs
Output (Q)
SRAC1
SRAC3
AR
(Demand)
MR
MC1
MC2
P1
P2
Q1 Q2
Profit at Price P1
Profit at Price P2

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Government policy and innovation
Supply-side strategies are usually linked directly with attempts to promote more innovative
behaviour. Indeed the focus of government policy is firmly focused on improvements in the
microeconomics of markets.
Which policies might encourage more innovation?
o Tax credits / capital investment allowances.
o Policies to encourage small business creation and entrepreneurship.
o Toughening up of competition policy to expose cartel behaviour, but to allow and promote
joint ventures to fund research and development.
o Lower corporation taxes to encourage innovative foreign companies to establish in Britain.
o Increased funding for research in our universities.
Important developments:
1. Increasingly most innovation is done by smaller firms and by entrepreneurs– indeed
multinational corporations are now out-sourcing their research and development spending
to small businesses at home and overseas – much is being shifted to cheaper locations
―offshore‖—in India and Russia. See this article on entrepreneurship in the Economist.
2. Innovation is now a continuous process – in part because the length of the product
cycle is getting shorter as innovations are rapidly copied by competitors, pushing down
profit margins and (according to a recent article in the economist) ―transforming today's
consumer sensation into tomorrow's commonplace commodity‖ – a good example of this is
the introduction of two major competitors to the anti-impotence drug Viagra!
3. Innovation is not something left to chance – the most successful firms are those that
pursue innovation in a systematic fashion – it becomes part of their corporate culture.
4. Demand innovation is becoming more important: In many markets, demand is either
stable or in decline. The response is to go for ―demand innovation‖ - discovering fresh
demand from consumers and adapting an existing product to meet them – the toy industry
is a classic example of this.
Suggestions for further reading on the economics of innovation and technological change
Britain‘s brilliant ideas boom (Money Programme, November 2007)
Innovation is transforming NHS care (BBC news, July 2008)
Microsoft‘s survival strategy (BBC news, May 2008)
Secret of Bill Gates‘ success (Money Programme, June 2008)
The many faces of innovation (The Economist, July 2008)
The technology of teaching (BBC news, March 2008)
Video games make history in 2007 (BBC news, December 2007)
Xerox plans the future of today (BBC news, May 2008)

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9. The Growth of Firms
Why do firms seek to grow?
The following factors are commonly
associated with the desire of firms to
grow:
1. The profit motive: Businesses
grow to expand output and
achieve higher profit. The
stimulus to achieve year-on-year
growth is often provided by the
expectations placed on a
business by the capital markets.
The stock market valuation of a
firm is influenced by
expectations of future sales and profit streams so if a company achieves disappointing
growth figures, this might be reflected in a fall in a company‘s share price. This opens up
the risk of a hostile take-over and makes it more expensive for a quoted company to raise
fresh capital by issuing new shares onto the market.
2. The cost motive: Economies of scale have the effect of increasing the productive
capacity of the business and they help to raise profit margins. They also give a business
a competitive edge in domestic and international markets.
3. The market power motive: Firms may wish to grow to increase their market dominance
thereby giving them increased pricing power in specific markets. Monopolies for example
can engage in price discrimination.
4. The risk motive: The expansion of a business might be motivated by a desire to diversify
production so that falling sales in one market might be compensated by stronger demand
and output in another market.
5. Managerial motives: Behavioural theories of the firm predict that the growth of a business
is often spurred on by the decisions and strategies of managers employed by a firm whose
objectives might be different from those with an equity stake in the business.
How do firms grow?
Organic growth
This is also known as internal growth and comes about from a business expanding its own
operations rather than relying on takeovers and mergers. Organic growth might come about from:
Expansion of existing production capacity
Investment in new capital & technology
Adding to the workforce
Developing & launch of new products
Growing a customer base through marketing

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External growth of a business
The fastest route for growth is through integration i.e. through mergers or contested take-overs. In
recent years there has been a boom in merger and takeover activity.
Horizontal integration: Horizontal integration occurs when two businesses in the same industry at
the same stage of production become one – for example a merger between two car
manufacturers or drinks suppliers. Recent examples of horizontal integration include:
Nike and Umbro
Body Shop and L'Oreal
NTL and Telewest (new business eventually renamed as Virgin Media)
Capital Radio and GWR to form GCap
AOL and Bebo
Tata and Jaguar
Virgin Active and Holmes Place
British Airways and Iberia Airlines
The advantages of horizontal integration include the following:
1. Increases the size of the business and allows for more internal economies of sale – lower
long run average costs – improved profits and competitiveness
2. One large firm may need fewer workers, managers and premises than two – a process
known as rationalization again designed to achieve cost savings
3. Mergers often justified by the existence of ―synergies‖
4. Creates a wider range of products - (diversification). Opportunities for economies of scope
5. Reduces competition by removing rivals – increases market share and pricing power
Vertical integration: Vertical Integration involves acquiring a business in the same industry but at
different stages of the supply chain. Examples of vertical integration might include the following:
Film distributors owning cinemas
Brewers owning and operating pubs
Tour operators / Charter Airlines / Travel Agents
Crude oil exploration all the way through to refined product sale
Record labels, record stations
Sportswear manufacturers and retailers
The main advantages of vertical integration are:
1. Greater control of the supply chain – this helps to reduce costs by eliminating intermediate
profit margins
2. Improved access to important raw materials
3. Better control over retail distribution channels

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Lateral Integration
This involves subsidiary companies joining together that produce similar but related products.
Good recent examples include:
eBay and Skype
Google and You Tube
Gillette and Proctor & Gamble
Other sources of monopoly power
Monopoly power also comes from owning patents and copyright protection or exclusive
ownership of productive assets (e.g. De Beers – diamonds). Monopoly power can also come
from winning bidding races for exclusive agreements – the best example of which is probably the
monopoly on broadcasting live soccer games on TV owned by BSkyB as a result of winning
auctions organised by the Premier League.
The government and its agencies may also give legal monopoly power to some business through
franchises and licences. Monopoly power can of course come organically through internal
growth where a firm takes advantage of economies of scale.
Stobart powers on
Undeterred by rising fuel costs and signs of an economic slowdown, Stobart the UK‘s largest road
haulier has continued to expand posting a 27% rise in revenues over the last year. The business
now operates 1,500 trucks and 2,900 trailers and has worked at 81% capacity utilisation, up from
71% four years ago. Stobart has grown externally by merging with fellow haulier Westbury and
acquiring O‘Connor, the inland container terminal operator. Stobart has also purchased transport
engineer WA Developments and has taken an option on buying Carlisle Airport. The business has
a strategy of building a mutli-modal capability mixing road, rail, sea and air transport.
Source: Adapted from news reports, June 2008
Outsourcing
The tendency of companies to outsource some of their production operations overseas has
become an important issue in recent years. Over 30% of UK companies now do some of their
production work abroad, whilst 10% have over half of their manufacturing offshore in lower cost
locations. Dyson is a high profile example of a company that has relocated production abroad to
Malaysia, whilst keeping their research and design operations in the UK. Most recently we are
witnessing a trend for service sector businesses to follow suit. In recent times we have seen
Norwich Union, Abbey National, Tesco, British Airways and National Rail Enquiries all transfer
parts of their operation overseas.
There are three main drivers promoting outsourcing as a business strategy:
(1) Technological change – Information, communication and telecommunication costs are
falling - this makes it much easier to outsource both service and manufacturing operations
to sub-contractors in other countries. Technological advances now promote "Just in time
delivery" inventory strategies for the delivery of components and finished products and
encourage the development of "virtual manufacturing". Communication costs are dropping

48
sharply - the average price of a one minute international call was 74% lower in 2003 than in
1993.
(2) Increased competition in a low-inflation environment - which increases the pressure on
businesses to achieve lower costs as a means of maintaining market share.
(3) Pressure from the financial markets for businesses to improve their profitability.
For many large businesses, there are clear cost advantages to be gained through doing business
via a call centre located overseas. Outsourcing is not simply confined to service sector industries.
Many manufacturing businesses are using outsourcing as a means of reducing their costs,
providing greater flexibility of production levels at times of volatile demand and also in speeding up
the time it takes to get their goods to market, especially new products.
Joint Ventures
Joint ventures occur when two or more businesses join together to pursue a common project or
goal. This type of business agreement is becoming common especially as firms become aware of
the potential of collaborative work in reaching a mutually strategic target. Firms might come
together for joint-research projects e.g. in sharing some of the fixed costs of expensive research
projects.
Good examples of joint ventures include:
Sony Ericsson - mobile phone joint venture
Google and NASA
Hollywood studios fighting internet piracy
Hugo Boss and Proctor & Gamble
Boeing and Lockheed
MySpace and Skype
Renault-Nissan‘s joint venture with Indian firm Bajaj to produce a £1,276 car
Evaluation comments on mergers and takeovers
Many takeovers and mergers fail to achieve their aims.
1. Financial costs of funding takeovers including the burden of deals that have relied heavily
on loan finance
2. The need to raise fresh equity to fund a deal which can have a negative impact on a
company's share price
3. Many mergers fail to enhance shareholder value because of clashes of corporate cultures
and a failure to find the all-important "synergy gains―
4. With the benefit of hindsight we often see the „winners curse‟ - i.e. companies paying over
the odds to take control of a business and ending up with little real gain in the medium term.
5. Competition policy concerns can come into play especially when there is a risk of monopoly
power from vertical and horizontal integration
6. Integration often leads to sizeable job losses with economic and social consequences

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The survival of smaller businesses in the economy
Over time there is a clear trend towards larger scale business operations partly because of the
pressures of competition; the need to achieve economies of scale and the effects of mergers and
takeovers. However this process is not purely a one-way street. There are plenty of examples
where businesses are de-merging and divesting themselves of some of their existing assets. And
even in industries where giant businesses dominate the market place, there is frequently room for
smaller firms to compete and survive profitably.
1. Many smaller businesses can make profits by acting as a supplier / sub-contractor to larger
enterprises
2. They might take advantage of a low price elasticity of demand and high income elasticity of
demand for specialist ‗niche‘ goods and services
3. Smaller businesses are often highly innovative, flexible and can avoid diseconomies of
scale
Private equity
Private equity is the name given to a particular type of company ownership. Some businesses such
as Tesco plc or British Petroleum plc are publicly-owned by outside investors who can buy and sell
their shares on the stock market. In contrast, privately-owned firms are owned by groups of
individuals or families and also by private equity funds. These funds raise capital from institutions
such as pension funds and make investments in companies that they feel can be improved and
achieve higher profits.
Some of the better known private equity firms include Permira, KKR (Kohlberg, Kravis and
Roberts) and 3i. In recent years, private equity firms have acquired a string of well-known business
names in the UK ranging from Birds-Eye frozen foods to Saga holidays, from Fitness First gyms to
Madam Tussauds Group. Some commentators have called them ‗casino capitalists‘ borrowing
heavily to fund takeover bids for companies and then engaging in severe asset stripping to realise
the values of newly bought businesses. Defenders of private equity believe that they can provide a
means by which inefficient management is removed and that successful takeovers can create
many more jobs than they lose over the medium term.
Demergers
A demerger is the opposite of a merger or acquisition and happens when a business decides to
spin off one or more of the businesses that it owns into a separate company - this might take the
form of a management buy-out. A demerger may be full, or partial. A partial demerger means that
the parent company retains a stake (sometimes a majority stake) in the demerged business. The
aim is nearly always to improve shareholder value by giving new management to chance to focus
on a particular core business and also to reduce levels of debt. Demergers can also result from
government intervention - perhaps because the competition authorities want a business with
monopoly power to be broken up to some extent to maintain competition.
Examples of recent demergers
1. Demerger of Cadbury's North American drinks business creating a new business called Dr
Pepper Snapple Group (DPSG)

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2. Severn Trent Water demerged its waste management business Biffa
3. Demerger of British Gas into the UK gas pipeline business Transco and an international oil
and gas exploration company
4. Woolworths was demerged from Kingfisher
Suggestions for further reading on the growth of firms
Amazon boss on profits rise (BBC news, July 2008)
Cadbury to go ahead with split (BBC news, August 2007)
Clubbing together to beat the big boys (BBC news, July 2008)
Co-op buys Somerfield for £1.57bn (BBC news, July 2008)
Face hooked – the growth of Facebook (Money Programme, December 2007)
Organic growth for Costa (Tutor2u blog, April 2008)

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10. Perfect Competition
Perfect competition – a pure market
Perfect competition describes a market structure whose assumptions are strong and therefore
unlikely to exist in most real-world markets.
Economists have become more interested in pure competition partly because of the growth of e-
commerce as a means of buying and selling goods and services. And also because of the
popularity of auctions as a device for allocating scarce resources among competing ends.
Assumptions for a perfectly competitive market
1. Many small firms, each of whom produces a low percentage of market output and thus
exercises no control over the ruling price.
2. Many individual buyers, none of whom has any control over the market price – i.e. there
is no monopsony power.
3. Perfect freedom of entry and exit from the industry. Firms face no sunk costs and
entry and exit from the market is feasible in the long run. This assumption means that all
firms in a perfectly competitive market make normal profits in the long run.
4. Homogeneous products are supplied to the markets that are perfect substitutes. This
leads to each firms being ―price takers‖ with a perfectly elastic demand curve for their
product.
5. Perfect knowledge – consumers have all readily available information about prices and
products from competing suppliers and can access this at zero cost – in other words, there
are few transactions costs involved in searching for the required information about prices.
6. No externalities arising from production and/or consumption which lie outside the market.
The real world of imperfect competition!
It is often said that perfect competition is a market structure that belongs to old fashioned textbooks
and is not worthy of study! Clearly the assumptions of pure competition do not hold in the vast

52
majority of real-world markets, for example, some suppliers may exert control over the amount of
goods and services supplied and exploit their monopoly power.
On the demand-side, some consumers may have monopsony power against their suppliers
because they purchase a high percentage of total demand. Think for example about the buying
power wielded by the major supermarkets when it comes to sourcing food and drink from food
processing businesses and farmers. The Competition Commission has been involved in lengthy
and detailed investigations into the market power of the major supermarkets.
In addition, there are nearly always some barriers to the contestability of a market and far from
being homogeneous; most markets are full of heterogeneous products due to product
differentiation – in other words, products are made different to attract separate groups of
consumers.
Consumers have imperfect information and their preferences and choices can be influenced by
the effects of persuasive marketing and advertising. In every industry we can find examples of
asymmetric information where the seller knows more about quality of good than buyer – a
frequently quoted example is the market for second-hand cars! The real world is one in which
negative and positive externalities from both production and consumption are numerous – both
of which can lead to a divergence between private and social costs and benefits. Finally there may
be imperfect competition in related markets such as the market for key raw materials, labour and
capital goods.
Adding all of these points together, it seems that we can come close to a world of perfect
competition but in practice there are nearly always barriers to pure competition. That said there are
examples of markets which are highly competitive and which display many, if not all, of the
requirements needed for perfect competition. In the example below we look at the global market for
currencies.
Currency markets - taking us closer to perfect competition
The global foreign exchange market is where all buying and selling of world currencies
takes place. There is 24-hour trading, 5 days a week.
Trade volume in the Forex market is around $3 trillion per day – equivalent to the annual
GDP of a country such as France! 31% of global currency trading takes place in London
alone – a world financial centre.
Well over ninety per cent of trading in currencies is ‗speculative‘ rather than the buying and
selling of currencies to enable people and firms to conduct business such as the financing
of international trade or traveling overseas.
The main players in the currency markets are as follows:
Banks both as ―market makers‖ dealing in currencies and also as end-users demanding
currency for their own operations. These banks include investment banks such as Merrill
Lynch and JP Morgan and commercial ―high street‖ banks such as Barclays and Lloyds
TSB.
Hedge funds and other institutions (e.g. funds invested by asset managers, pension
funds).
Central Banks (including occasional currency intervention in the market when they buy
and sell to manipulate an exchange rate in a particular direction).
Corporations (who may use the currency market for defensive ‗hedging‘ of exposures to
risk such as volatile oil and gas prices.)

53
Private investors and people remitting money earned overseas to their country of origin /
market speculators trading in currencies for their own gain / tourists going on holiday and
people traveling around the world on business.
Why does a currency market come close to perfect competition?
Homogenous output: The "goods" traded in the foreign exchange markets are
homogenous - a US dollar is a dollar and a euro is a euro whether someone is trading it in
London, New York or Tokyo.
Many buyers and sellers meet openly to determine prices: There are large numbers of
buyers and sellers - each of the major banks has a foreign exchange trading floor which
helps to "make the market". Indeed there are so many sellers operating around the world
that the currency exchanges are open for business twenty-four hours a day. No one agent
in the currency market can, on their own influence price on a persistent basis - all are ‗price
takers‘. According to Forex_Broker.net "The intensity and quantity of buyers and sellers
ready for deals doesn't allow separate big participants to move the market in joint effort in
their own interests on a long-term basis."
Currency values are determined solely by market demand and supply factors.
High quality real-time information and low transactions costs: Most buyers or sellers
are well informed with access to real-time market information and background research
analysis on the factors driving the prices of each individual currency. Technological
progress has made more information immediately available at a fraction of the cost of just a
few years ago. This is not to say that information is cheap - an annual subscription to a
Bloomberg or a Reuter‘s news terminal will cost several thousand dollars. But the market is
rich with information and transactions costs for each batch of currency bought and sold has
come down.
Seeking the best price: The buyers and sellers in foreign exchange only deal with those
who offer the best prices. Technology allows them to find the best price quickly.
What are the limitations of currency trading as
an example of a competitive market?
Firstly the market can be influenced by
official intervention via buying and
selling of currencies by governments or
central banks operating on their behalf.
There is a huge debate about the actual
impact of intervention by policy-makers
in the currency markets.
Secondly there are high fixed costs
involved in a bank or other financial
institution when establishing a new
trading platform for currencies. They
need the capital equipment to trade effectively; the skilled labour to employ as currency
traders and researchers. Some of these costs may be counted as sunk costs – hard to
recover if a decision is made to leave the market.
Despite these limitations, the foreign currency markets take us reasonably close to a world of
perfect competition. Much the same can be said for trading in the equities and bond markets and
also the ever expanding range of future markets for financial investments and internationally traded
commodities. Other examples of competitive markets can be found on a local scale – for example

54
a local farmers‘ market where there might be a sizeable number of farmers offering their produce
for sale.
The internet and perfect competition
Advances in internet technology have made some markets more competitive. It has certainly
reduced the barriers to entry for firms wanting to compete with well established businesses – for
example specialist toy retailers are better able to battle for market share with the dominant retailers
such as ToysRUs and Wal-Mart.
One of the most important aspects of the internet is the ability of consumers to find information
about prices for many goods and services. There are an enormous number of price comparison
sites in the UK covering everything from digital cameras to package holidays, car insurance to CDs
and jewellery.
That said the price comparison web sites themselves have come under criticism in recent times.
For example the sites offering to compare hundreds of different motor insurance policies or
mortgage products draw information from the insurance and mortgage brokers but might use
limiting assumptions about the different types of consumers looking for the best price – the result is
a range of prices facing the consumer that don‘t accurately reflect their precise needs – and
consumers may only realise this when, for example, they make a claim on an insurance policy
bought over the internet which turns out not to provide the specific cover they needed.
And in the market for price comparison sites there is monopoly power too! Moneysupermarket.com
currently has around 40% of the overall comparison site market, with Confused.com its nearest
rival with a share of about 10%.
Price and output in the short run under perfect competition
In the short run, the interaction between demand and supply determines the “market-clearing”
price. A price P1 is established and output Q1 is produced. This price is taken by each firm. The
average revenue curve is their individual demand curve.
Since the market price is constant for each unit sold, the AR curve also becomes the marginal
revenue curve (MR) for a firm in perfect competition.
Output (Q)Output (Q)
Market Demand and
Supply
Individual Firm‘s Costs and
RevenuesPrice (P) Price (P)
Market
Demand
Market
Supply
P1
Q1
AR (Demand) = MR
MC (Supply)
AC
P1
AC1
Q2

55
For the firm, the profit maximising output is at Q2 where MC=MR. This output generates a total
revenue (P1 x Q2). Since total revenue exceeds total cost, the firm in our example is making
abnormal (economic) profits.
This is not necessarily the case for all firms in the industry since it depends on the position of their
short run cost curves. Some firms may be experiencing sub-normal profits if average costs exceed
the price – and total costs will be greater than total revenue.
Short run losses
The adjustment to the long-run equilibrium in perfect competition
If most firms are making abnormal profits in the short run, this encourages the entry of new
firms into the industry, which will cause an outward shift in market supply forcing down the ruling
price.
The increase in supply will eventually reduce the price until price = long run average cost. At this
point, each firm in the industry is making normal profit. Other things remaining the same, there is
no further incentive for movement of firms in and out of the industry and a long-run equilibrium has
been established. This is shown in the next diagram.
Output (Q)Industry Output (Q)
Market Demand and
Supply
Individual Firm‘s Costs and
RevenuesPrice (P) Price (P)
MD1
Market
Supply
P1
Q1
AR = MR
MC (Supply)
AC
P1
Q2
MD2
P2
AR2 (Demand) =
MR2
AC2

56
We are assuming in the diagram above that there has been no shift in market demand. The effect
of increased supply is to force down the price and cause an expansion along the market demand
curve. But for each supplier, the price they ―take‖ is now lower and it is this that drives down the
level of profit made towards normal profit equilibrium.
In an exam question you may be asked to trace and analyse what might happen if
1. There was a change in market demand (e.g. arising from changes in the relative prices of
substitute products or complements.)
2. There was a cost-reducing innovation affecting all firms in the market or an external
shock that increases the variable costs of all producers.
Adam Smith on Competition
―The natural price or the price of free competition ... is the lowest which can be taken. [It] is the
lowest which the sellers can commonly afford to take, and at the same time continue their
business.‖
Source: Adam Smith, the Wealth of Nations (1776), Book I, Chapter VII
The common characteristics of markets that are considered to be ―competitive‖ are:
Lower prices because of many competing firms. Suppliers face elastic demand curves and
any rise in price will lead to a fall in demand and in total revenue. The cross-price
elasticity of demand for one product will be high suggesting that consumers are prepared
to switch their demand to the most competitively priced products in the market-place.
Low barriers to entry – the entry of new firms provides competition and ensures prices are
kept low in the long run.
Lower total profits and profit margins than in markets which dominated by a few firms.
Greater entrepreneurial activity – the Austrian school of economics argues that true
competition is a process rather than a static condition. For competition to be improved and
sustained there needs to be a genuine desire on behalf of entrepreneurs to engage in
Market Demand and Supply Individual Firm‘s Costs and Revenues
Price (P) Price (P)
Market
Demand
Market
Supply
(MS)
P1
Q1
AR1 = MR1
MC (Supply)
AC
P1
Q3
P2 P2
AR2 = MR2
Q2
MS2
P2
Long run
equilibrium
output

57
competitive behaviour, to innovate and to invent to drive markets forward and create what
Joseph Schumpeter famously called the ―gales of creative destruction‖.
Economic efficiency – competition will ensure that firms attempt to move towards
productive efficiency. The threat of competition should lead to a faster rate of technological
diffusion, as firms have to be particularly responsive to the changing needs of consumers.
This is known as dynamic efficiency.
The importance of non-price competition
In competitive markets, frequently it is the effectiveness of non-price competition which is crucial
in winning sales and protecting or enhancing market share. Digest this example from the market
for sandwiches!
Perfect competition and efficiency
Perfect competition can be used as a yardstick to compare with other market structures because
it displays high levels of economic efficiency.
1. Allocative efficiency: In both the short and long run we find that price is equal to marginal
cost (P=MC) and thus allocative efficiency is achieved. At the ruling price, consumer and
producer surplus are maximised. No one can be made better off without making some other
agent at least as worse off – i.e. we achieve a Pareto optimum allocation of resources.
2. Productive efficiency: Productive efficiency occurs when the equilibrium output is
supplied at minimum average cost. This is attained in the long run equilibrium for a
competitive market. Firms with high unit costs may not be able to justify remaining in the
industry as the market price is driven down by the forces of competition.
3. Dynamic efficiency: We assume that a perfectly competitive market produces
homogeneous products – in other words, there is little scope for innovation designed purely
to make products differentiated from each other and allow a supplier to develop and then
exploit a competitive advantage in the market to establish some monopoly power.
Some economists claim that perfect competition is not a good market structure for high levels of
research and development spending and the resulting product and process innovations.
Indeed it may be the case that monopolistic or oligopolistic markets are more effective long term in
creating the environment for research and innovation to flourish. A cost-reducing innovation from
one producer will, under the assumption of perfect information, be immediately and without cost
transferred to all of the other suppliers.
That said a highly contestable market provides the discipline on firms to keep their costs under
control, to seek to minimise wastage of scarce resources and to refrain from exploiting the
consumer by setting high prices and enjoying high profit margins. In this sense, competition can
stimulate improvements in both static and dynamic efficiency over time. It is certainly one of the
main themes running through the recent toughening-up of UK and European competition policy as
this passage from a recent DTI analysis suggests:
The long run of perfect competition, therefore, exhibits optimal levels of economic efficiency. But
for this to be achieved all of the conditions of perfect competition must hold – including in related
markets. When the assumptions are dropped, we move into a world of imperfect competition with
all of the potential that exists for various forms of market failure.

58
Suggestions for further reading on aspects of competitive markets
Consumers in danger of being misled by price comparison sites (Independent, October 2007)
Tesco adds to contestability in digital downloads (Tutor2u blog, April 2008)
Costs
Revenues
Output (Q)
AR (Demand)
MC (Supply)
P1
Q1
Consumer
Surplus (CS)
Producer
Surplus (PS)
P2
Q2
Net Loss of Economic
Welfare from price P2
raised above marginal cost
Market equilibrium output where
demand = supply and where price
= marginal cost of production

59
11. Monopolistic Competition
Monopolistic competition is a form of imperfect competition and can be found in many real world
markets ranging from clusters of sandwich bars and coffee stores in a busy town centre to pizza
delivery businesses in a city or hairdressers in a local area. Small-scale nurseries and care homes
for older people might also fit into the market structure known as monopolistic competition.
The assumptions of monopolistic competition are as follows - as you check through them look to
see the differences between this mark structure and perfect competition.
1. There are many producers and many consumers in a market - the concentration ratio is
low
2. Consumers perceive that there are non-price differences among the competitors' products
i.e. there is product differentiation
3. Producers have some control over price - they are ―price makers‖ rather than ―price
takers.‖
AC1
P1
MR
AR
Price and
Cost
Quantity of Output
AC
MC
Q1

60
4. The barriers to entry and exit into and out of the market are low
In the short run the profits made by businesses competing in this type of market structure can be at
any level - in our example below the business is making supernormal profits indicated by the
shaded area. One of the predictions of the model is that high levels of abnormal profit will attract
new suppliers and new products into the market the effect of which might be to reduce the demand
for existing products and reduce profits down towards normal profit equilibrium.
Strong brand loyalty can have the effect of making demand less sensitive to price.
The long run equilibrium may be as shown in our second diagram - with normal profits being
made. The reality is that a stable equilibrium is never reached - new products come and go all of
the time, some do better than others. Existing products within a market will typically go through a
product life cycle which affects the volume and growth of sales.
One of the possible implications of monopolistic competition is that an inefficient outcome is
reached. Prices are above marginal cost and saturation of the market may lead to businesses
being unable to exploit fully the internal economies of scale - causing average cost to be higher
than if the market was being supplied by less firms and products. Critics of heavy spending on
marketing and advertising argue that much of this spending is wasted and is an inefficient use of
scarce resources. The debate over the environmental impact of packaging is linked strongly to this
aspect of monopolistic competition.
P2 = AC2
MR
AR
Price and
Cost
Quantity of Output
AC
MC
Q2

61
Case Study: Competition in the market for nursery education
Recently, one leading company has taken the decision to withdraw from the nursery market,
whereas another has set a clear strategy to achieve market leadership through acquisitions. What
lies behind the different approaches?
In August 2007 Nord Anglia decided to sell its market-leading nursery operation for less than half
the price it paid to build the business. Nord Anglia sold its 88 kindergartens to Busy Bees, an
Australian-owned company, for £31.2 million. It blamed over-capacity in the nursery market and
the lack of economies of scale as the main reasons for the disposal. In 2006, Nord Anglia made a
loss of £3.5 million on its nursery operation, on turnover of £47.1 million. For Busy Bees, the
acquisition catapulted the business into the number one position in the nursery market, giving it a
total of 134 nurseries across the UK. John Woodward, the entrepreneur who founded Busy Bees
with a single site 25 years ago wants to make Busy Bees into a ―major childcare brand‖.
The UK nursery market is worth around £500 million and is currently highly fragmented, with
some 85% of operations being ―mom and pop‖ style individual sites. The total number of private
nurseries is around 15,000. One problem facing all nursery operators is that the business is
labour-intensive. One member of staff is needed to look after every three babies or seven
toddlers. Nursery staff costs are around 60% of revenue. To be sustainable, a nursery has to be at
least 60% full in each of its ten sessions in a week, although many customers choose not to use a
nursery for a full week.
Source: Business Café, September 2007

62
12. The Model of Monopoly
What do we mean by market concentration?
When we focus on industries where one or more firms have significant market power we often use
the term concentration ratio. This measures the market share of the top n firms in the industry.
Share can be by sales, employment or any other relevant indicator. The value of n is often five, but
may be three or any other small number. If the top n firms gain a greater market share the industry
is said to have become more highly concentrated. Our example below is taken from the June 2008
figures for market share in the UK food retail sector.
The 3 firm concentration ratio is measured at 63.9%
The 5 firm concentration ratio is measured at 83.4%
This market structure suggests an oligopoly – but each of the businesses has ‗market
power‘ in the sense that each has control over the products it sells and the prices it
charges.
The data is for the national economy – local and regional concentration ratios might be very
different from that shown – e.g. the local monopoly power enjoyed by one or more
businesses. The UK competition authorities are very aware of this when they investigate
markets.
MARKET SHARE
(%)
CUMULATIVE MARKET
SHARE
(%)
Tesco 31.2 31.2
Asda (Wal-Mart) 16.8 48.0
Sainsbury‘s 15.9 63.9
Morrisons (Safeways) 11.4 75.3
Co-operative (Somerfield) 8.1 83.4
Waitrose 3.9 87.3
Aldi 2.9 90.2
Lidl 2.3 92.5
Iceland 1.7 94.2
1. A pure monopolist in an industry is a single seller. It is quite rare for a firm to have a pure
monopoly – except when the industry is state-owned and has a legally protected monopoly.
The Royal Mail used to have a statutory monopoly on delivering household mail. But this
is now changing fast as the industry has been opened up to fresh competition.
2. A working monopoly: A working monopoly is any firm with greater than 25% of the
industries' total sales. In practice, there are many markets where businesses enjoy some
degree of monopoly power even if they do not have a twenty-five per cent market share.
Price and output under a pure monopoly
A pure monopolist is a single seller in an industry – in this case, the firm is the industry – and it
can take market demand as its own demand curve. The firm is a price maker but a monopoly
cannot charge a price that the consumers in the market will not bear. In this sense, the price
elasticity of the demand curve acts as a constraint on the pricing-power of the monopolist.

63
Assuming that the monopolist aims to maximise profits (where MR=MC), we establish a short run
price and output equilibrium as shown in the diagram below.
The profit-maximising level of output is at Q1 at a price P1. This will generate total revenue equal
to OP1aQ1, but the total cost will be OAC1aQ. As total revenue exceeds total costs the firm makes
abnormal (supernormal) profits equal to P1baAC1.
The effect of a rise in costs on monopoly price and profits
AC
Monopoly demand
(AR) = market
demand
MR
MC
Q1
Monopoly Profit
at Price P1
Revenue
Cost and
Profit
Output (Q)
P1
AC1
Short run price and output under a pure monopoly – the average revenue curve is assumed to
be the market demand curve. A pure monopoly is a single seller of a product in a given
market. The firm is the industry and has a 100% market share
b
a

64
The rise in price from P1 to P2 helps the monopolist to absorb some of the rise in costs, but the net
effect is a reduction in profits and a contraction in output from Q1 to Q2. The extent to which a
business can pass on a rise in costs depends on the price elasticity of demand – ‗pricing power‘ is
greatest when demand is price inelastic, i.e. consumers are not price-sensitive.
AC1
Monopoly
Demand (AR)
MR
MC1
Q1
Monopoly Profit
at Price P1
Revenue
Cost and
Profit
Output (Q)
P1
AC1
AC2
MC2
Q2
P2
AC2
Monopoly Profit
at Price P2

65
13. Barriers to Entry and Exit in Markets
Barriers to entry are designed to block potential entrants from entering a market profitably.
They seek to protect the power of existing firms and maintain supernormal profits and
increase producer surplus. These barriers have the effect of making a market less contestable -
they are also important because they determine the extent to which well-established firms can
price above marginal and average cost in the long run.
The 1982 Nobel Prize winning economist George Stigler defined an entry barrier as ―A cost of
producing which must be borne by a firm which seeks to enter an industry but is not borne by
businesses already in the industry‖.
Another Economist, George Bain defined entry barriers as ―The extent to which established firms
can elevate their selling prices above minimum average cost without inducing potential entrants to
enter an industry‖.
The Bain interpretation of entry barriers emphasises the asymmetry in costs that often exists
between the incumbent firm and the potential entrant. If the existing businesses have managed to
exploit economies of scale and developed a cost advantage over potential entrants, this might
be used to cut prices if and when new suppliers enter the market. This is a move away from short-
run profit maximisation objectives – but it is designed to inflict losses on new firms and protect a
dominant market position in the long-run. The monopolist might then revert back to profit
maximization once a new entrant has been sent packing!
Another way of categorising entry barriers is
summarised below
o Structural barriers (also known as
‗innocent‘ entry barriers) – arising from
differences in production costs.
o Strategic barriers (see the notes below on
strategic entry deterrence).
o Statutory barriers – these are entry
barriers given force of law (e.g. patent
protection of franchises such as the National
Lottery or television and radio broadcasting licences).
Entry barriers exist when costs are higher for an entrant than for the incumbent firms. This is
shown in the next diagram.
The incumbent monopolist has achieved economies of scale so that that its own LRAC and LRMC
are lower than that of a potential entrant. If the monopolist maintains a profit maximising price of
P1, a market entrant could achieve above normal profits since its costs are lower than the
prevailing price. At any price below Pe the potential entrant will make a loss – and entry can be
blockaded.

66
Theory of Early Mover or First Mover Advantage
Sometimes there are sizeable advantages to being first into a market – first-movers can establish
themselves, build a customer base and make life difficult for new firms on the scene. The first-
mover idea is summarised thus:
Grow first & become larger Achieve economies of scale  Bigger business  generates the
resources to do more innovation  More innovation leads to better products and lower costs 
Catalyst to grow bigger  Eventually no entrant can compete Later entrants may be forced to
exit the market
Barriers to Exit – (Sunk Costs)
Whilst textbooks tend to concentrate on the costs of entering a market, often it is the financial
implications of leaving an industry that act as one of the most important barriers – hence we need
to consider exit costs. A good example of these is the presence of sunk costs.
Sunk costs cannot be recovered if a business decides to leave an industry. Examples include:
o Capital inputs that are specific to an industry and which have little or no resale value.
o Money spent on advertising, marketing and research and development projects which
cannot be carried forward into another market or industry.
When sunk costs are high, a market becomes less contestable. High sunk costs act as a barrier
to entry of new firms because they risk making huge losses if they decide to leave a market. In
contrast, markets such as fast-food restaurants, sandwich bars, hairdressing salons and local
antiques markets have low sunk costs so the barriers to exit are low.
o Asset-write-offs – e.g. the expense associated with writing-off items of plant and
machinery, stocks and the goodwill of a brand
o Closure costs including redundancy costs, contract contingencies with suppliers and the
penalty costs from ending leasing arrangements for property
LRAC = LRMC (Existing
Monopolist)
Monopoly
Demand (AR)
MR
Q1
Revenue
Cost and
Profit
Output (Q)
P1
Pc
Qc
B
A
C
AC = MC (Potential
Entrant into the market)
D

67
o The loss of business reputation and goodwill - a decision to leave a market can
seriously affect goodwill among previous customers, not least those who have bought a
product which is then withdrawn and for which replacement parts become difficult or
impossible to obtain.
o A market downturn may be perceived as temporary and could be overcome when the
economic or business cycle turns and conditions become more favourable
Strategic Entry Deterrence
Strategic entry deterrence involves any move by existing firms to reinforce their position against
other firms of potential rivals. There are plenty of examples of this – including the following:
o Hostile takeovers and acquisitions – taking a stake in a rival firm or buying it up!
o Product differentiation through brand proliferation (i.e. investment in developing new
products and spending on marketing and advertising to reinforce consumer / brand loyalty).
o Capacity expansion to achieve lower unit costs from exploiting internal economies of
scale.
o Predatory pricing: Predatory behaviour is defined as a dominant company sustaining
losses in the short run with the knowledge it will be able to recoup them once the
competition is forced to exit, and is in breach of the Competition Act 1998. We return to this
in the chapter on oligopoly and cartels.
Strategic barriers may be deemed anti-competitive by the British and EU competition
authorities - The EU Competition Commission has been active in recent years in building cases
against European businesses that have engaged in anti-competitive practices including price
fixing cartels.
Allegations of predatory pricing in the Cardiff bus market
Cardiff's main bus company has been accused of "predatory behaviour" in an investigation by the
Office of Fair Trading (OFT). The OFT found that the Cardiff Bus Company, which carries an
estimated 80,000 people each weekday in Cardiff, used its dominant position to run its no frills
services with revenues so far below costs that it was impossible for its competitor (2Travel plc) to
remain in the market. Cardiff Bus denied it had infringed competition law.
Sources: News reports and the Office of Fair Trading
Borders v Amazon
Borders bookstore has broken away from Amazon after seven years to launch its own standalone
website. Borders.com will have a total of 2 million books and DVDs in its inventory. In addition, in
an agreement with Alibris, Borders will now offer about 60 million used books for sale. The site also
features a link to its cobranded e-bookstore with Sony and has the ability to download digital audio
either in DRM or DRM-free formats. The success or failure of the attempt by Borders to break the
stranglehold of Amazon in the battle for market share in the UK will be an interesting test case of
the scale of barriers to entry and the power of first mover advantage.
Source: Tutor2u blog, June 2008
Despite the inevitability of entry and exit barriers markets are constantly evolving and we often do
witness the entry of new suppliers even when one or more firms have a clear position of market
power. Entry can occur in a variety of ways:
1. A takeover from outside the industry (sometimes known as the ―Trojan-horse route‖ to
by-pass any structural entry barriers that might exist within an industry.)

68
2. A transfer of brand names from one sector of the economy to another (for example
the diversification practiced by both EasyGroup, Virgin and Stagecoach in recent years.)
3. Increasing competition from overseas – i.e. the liberalisation of markets around the
world
Case Study: Water – A Case for Competition?
Since 1989 the number of water authorities in the UK has fallen from 39 to 27 as a result of
horizontal integration. In addition to the concern of many the ownership of UK water companies
has increasingly fallen into foreign ownership. Most customers have no choice about who
supplies them with water and they are generally supplied with their nearest water company.
The Water Services Regulation Authority (Ofwat) monitors standards of service (such as
leakage repair and how quickly complaints are dealt with) and also the prices charged to
customers. Due to the huge amount of investment required to improve the UK‘s water
infrastructure and to meet European Union water quality standards prices to customers have risen
above the rate of inflation (thus rising in real terms).
Over the years the government has attempted to open up the water industry to competition
enabling customers to choose their supplier. In 2003, legislation was introduced seeking to open
up the market by allowing customers using more than 50 million litres of water a year to choose to
switch suppliers and this threshold may be reduced in the years ahead. But for millions of
individual households, there is little chance of effective competition.
A national grid for water is some way off not least because of the expenditure involved in
creating one, but the water industry could copy the principle of „common carriage‟ which enables
competition to occur in the energy sector. This would mean that a new entrant to the water supply
market would be allowed access to the supply network by the existing monopoly firm. With the help
of the regulator entry barriers to the water industry could be lowered and competition introduced.
This would make the market more contestable but the existing firms would more than likely have
huge economies of scale advantages over any new entrant.
With climate change affecting water supply, the continued problem of leaking pipes and debate
over the introduction of household water metering the future of the water industry will remain high
on the political agenda.
Source: Robert Nutter, EconoMax, May 2008
Suggestions for further reading:
Water companies are not being encouraged to be innovative and efficient (Telegraph, July 2008)

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14. Price Discrimination
Most businesses charge different prices to different groups of consumers for the same good or
service! This is price discrimination. Businesses could make more money if they treated everyone
as individuals and charged them the price they are willing to pay. But doing this involves a cost –
they have to find the right pricing strategy for each part of the market they serve – their revenues
should rise, but marketing costs will also increase.
What is price discrimination?
Price discrimination or yield management occurs when a business charges a different price to
different groups of consumers for the same good or service, for reasons not associated with
costs.
It is important to stress that charging different prices for similar goods is not pure price
discrimination.
We must be careful to distinguish between price discrimination and product differentiation –
the latter gives the supplier greater control over price and the potential to charge consumers a
premium price because of actual or perceived differences in the quality or performance of a good
or service.
Conditions necessary for price discrimination to work
Essentially there are two main conditions required for discriminatory pricing:
o Differences in price elasticity of demand: There must be a different price elasticity of
demand for each group of consumers. The firm is then able to charge a higher price to the
group with a more price inelastic demand and a lower price to the group with a more elastic
demand. By adopting such a strategy, the firm can increase total revenue and profits (i.e.
achieve a higher level of producer surplus). To profit maximise, the firm will seek to set
marginal revenue = to marginal cost in each separate (segmented) market.
o Barriers to prevent consumers switching from one supplier to another: The firm must
be able to prevent “market seepage” or “consumer switching” – a process whereby
consumers who have purchased a product at a lower price are able to re-sell it to those
consumers who would have otherwise paid the expensive price. This can be done in a
number of ways, – and is probably easier to achieve with the provision of a unique service
such as a haircut, dental treatment or a consultation with a doctor rather than with the
exchange of tangible goods such as a meal in a restaurant. Seepage might be prevented
by selling a product to consumers at unique moments in time – for example with the use of
airline tickets for a specific flight that cannot be resold under any circumstances.
Examples of price discrimination
Price discrimination (Tim Harford calls it price targeting) is a common type of pricing strategy
operated by virtually every business with some pricing power. It is a classic part of competition
between firms seeking a market advantage or to protect an established position.
(a) Perfect Price Discrimination – or charging whatever the market will bear
Sometimes known as optimal pricing, with perfect price discrimination, the firm separates the
market into each individual consumer and charges them the price they are willing and able to pay.
If successful, the firm can extract the entire consumer surplus that lies underneath the demand

70
curve and turn it into extra revenue or producer surplus. This is impossible to achieve unless the
firm knows every consumer‟s individual preferences and willingness to pay and, as a result, is
unlikely to occur in the real world. The transactions costs involved in finding out through market
research what each buyer is prepared to pay is the main barrier to a businesses engaging in this
form of price discrimination.
If the monopolist is able to perfectly segment the market, then the average revenue curve
becomes the marginal revenue curve for the firm. The monopolist will continue to sell extra units as
long as the extra revenue exceeds the marginal cost of production.
In reality, most suppliers and consumers prefer to work with price lists and menus from which
trade can take place rather than having to negotiate a price for each unit of a product bought and
sold.
Second Degree Price Discrimination
This type of price discrimination involves businesses selling off packages of a product deemed to
be surplus capacity at lower prices than the previously published or advertised price. Price tends
to fall as the quantity bought increases.
Examples of this can be found in the hotel industry where spare rooms are sold on a last minute
standby basis. In these types of industry, the fixed costs of production are high. At the same time
the marginal or variable costs are small and predictable. If there are unsold rooms, it is often in
the hotel‘s best interest to offload any spare capacity at a discount prices, providing that the
cheaper price that adds to revenue at least covers the marginal cost of each unit.
There is nearly always some supplementary profit to be made from this strategy. And, it can also
be an effective way of securing additional market share within an oligopoly as the main
suppliers‘ battle for market dominance. Firms may be quite happy to accept a smaller profit margin
if it means that they manage to steal an advantage on their rival firms.
The expansion of e-commerce by both well established businesses and new entrants to online
retailing has seen a further growth in second degree price discrimination.
Early-bird discounts – extra cash-flow
Customers booking early with carriers such as EasyJet or RyanAir will normally find lower prices if
they are prepared to commit themselves to a flight by booking early. This gives the airline the
advantage of knowing how full their flights are likely to be and a source of cash-flow in the weeks
and months prior to the flight taking off. Closer to the time of the scheduled service the price rises,
on the justification that consumer‘s demand for a flight becomes inelastic the nearer to the time of
the service. People who book late often regard travel to their intended destination as a necessity
and they are likely to be willing and able to pay a much higher price.
The airlines have become masters at price
discrimination as a means of maximising revenue from
passengers travelling on the flight networks. Other
transport businesses do the same!

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Peak and Off-Peak Pricing
Peak and off-peak pricing and is common in the telecommunications industry, leisure retailing and
in the travel sector. Telephone and electricity companies separate markets by time: There are
three rates for telephone calls: a daytime peak rate, and an off peak evening rate and a cheaper
weekend rate. Electricity suppliers also offer cheaper off-peak electricity during the night.
At off-peak times, there is plenty of spare capacity and marginal costs of production are low (the
supply curve is elastic) whereas at peak times when demand is high, we expect that short run
supply becomes relatively inelastic as the supplier reaches capacity constraints. A combination
of higher demand and rising costs forces up the profit maximising price.
Third Degree (Multi-Market) Price Discrimination
This is the most frequently found form of price discrimination and involves charging different prices
for the same product in different segments of the market. The key is that third degree
discrimination is linked directly to consumers‟ willingness and ability to pay for a good or
service. It means that the prices charged may bear little or no relation to the cost of production.
The market is usually separated in two ways: by time or by geography. For example, exporters
may charge a higher price in overseas markets if demand is estimated to be more inelastic than it
is in home markets.
Supply (Marginal
Cost)
Off-Peak
Demand
Peak Demand
MR Off-Peak
MR Peak
Output Off-Peak Output Peak
Price,
Cost
Output
P1
P2

72
Suppose that a firm has separated a market by time into a peak market with inelastic demand, and
an off-peak market with elastic demand. The demand and marginal revenue curves for the peak
market and off peak markets are labelled A and B respectively. This is illustrated in the diagram
above. Assuming a constant marginal cost for supplying to each group of consumers, the firm aims
to charge a profit maximising price to each group.
In the peak market the firm will produce where MRa = MC and charge price Pa, and in the off-peak
market the firm will produce where MRb = MC and charge price Pb. Consumers with an inelastic
demand will pay a higher price (Pa) than those with an elastic demand who will be charged Pb.
The internet and price discrimination
The rapid expansion of e-commerce using the internet is giving manufacturers unprecedented
opportunities to experiment with different forms of price discrimination. Consumers on the net often
provide suppliers with a huge amount of information about themselves and their buying habits that
then give sellers scope for discriminatory pricing. For example Dell Computer charges different
prices for the same computer on its web pages, depending on whether the buyer is a state or local
government, or a small business.
Two Part Pricing Tariffs
Another pricing policy is to set a two-part tariff for consumers. A fixed fee is charged and then a
supplementary “variable” charge based on the number of units consumed. There are plenty of
examples of this including taxi fares, amusement park entrance charges and the fixed charges set
by the utilities (gas, water and electricity). Price discrimination can come from varying the fixed
charge to different segments of the market and in varying the charges on marginal units consumed
(e.g. discrimination by time).
Product-line pricing
Market A Market B
MC=AC
QuantityQuantity
Price
Price
Pa
Pb
MRa
MRb ARb
ARa
Profit from selling to market A –
with a relatively elastic demand –
and charging a lower price
Demand in segment B of the
market is relatively inelastic. A
higher unit price is charged
MC=AC
QbQa
MC=AC

73
Product line pricing occurs when there are many closely connected complementary products
that consumers may be enticed to buy. It is frequently observed that a producer may manufacture
many related products. They may choose to charge one low price for the core product (accepting a
lower mark-up or profit on cost) as a means of attracting customers to the components /
accessories that have a much higher mark-up or profit margin.
Good examples include manufacturers of cars, cameras, razors and games consoles. Indeed
discriminatory pricing techniques may take the form of offering the core product as a “loss-leader”
(i.e. priced below average cost) to induce consumers to then buy the complementary products
once they have been ―captured‖. Consider the cost of computer games consoles or Mach3 Razors
contrasted with the prices of the games software and the replacement blades!
Weddings and price discrimination
Mentioning that you need a room or a location for a wedding reception / party can add hundreds of
pounds to charges. People are paying over the odds because the demand for wedding services is
price inelastic. Bride and groom want everything to be perfect on their special day and many
venues will simply hike up the charge for the hire of a room for a wedding by several hundred
pounds, or a photographer will raise fees for an all-day event. Why should it cost so much more to
host a lunch reception following a wedding compared to exactly the same room, meal for a
corporate lunch or funeral wake? This is price discrimination at work. The average cost of a British
wedding set to rise to nearly £18,500. And research from home insurer Churchill has found that
British wedding guests spend £13.8 billion attending weddings every year. Weddings can be an
expensive business for all concerned!
Source: News reports
Amazon's US textbook rip-off
Are US students being ripped off by Amazon.com? Jonathan Dingel at Trade Diversion blog points
to a forthcoming paper by Yale's Christos Cabolis and colleagues, A Textbook Example of
International Price Discrimination (PDF). The paper finds that although books for general
audiences are similarly priced internationally, "textbooks are substantially more expensive in the
United States" (on amazon.com) than the UK (amazon.co.uk). They argue that "cost factors cannot
explain this phenomenon and discuss several demand-side explanations."
Source: Adapted from the New Economist blog, October 2006
Consequences of Price Discrimination
Who gains and who loses out from persistent and pervasive price targeting by businesses? To
what extent does price discrimination help to achieve an efficient allocation of resources? There
are many arguments on both sides of the coin – indeed the impact of price discrimination on
welfare seems bound to be ambiguous. We summarise some of these arguments below:
Impact on consumer welfare
Consumer surplus is reduced in most cases - representing a loss of consumer welfare. For the
majority of buyers, the price charged is well above the marginal cost of production. Those
consumers in market segments where demand is inelastic would probably prefer a return to
uniform pricing by firms with monopoly power!
However some consumers who can now buy the product at a lower price may benefit. Previously
they may have been excluded from consuming it. Lower-income consumers may be “priced into
the market” if the supplier is willing and able to charge them less. Good examples might include
legal and medical services where charges are dependent on income levels. Greater access to
these services may yield external benefits (positive externalities) which then have implications for

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the overall level of social welfare and the equity with which scarce resources are allocated. Drugs
companies might justify selling their products at inflated prices in countries where incomes are
higher because they can then sell the same drugs to patients in poorer countries.
Producer surplus and the use of profit
Price discrimination is clearly in the interests of businesses who achieve higher profits. A
discriminating monopoly is extracting consumer surplus and turning it into supernormal profit.
Of course businesses may not be driven solely by the aim of maximising profit. A company will
maximise its revenues if it can extract from each person the maximum amount that person is
willing to pay.
Price discrimination also might be used as a predatory pricing tactic to harm competition at the
supplier‘s level and increase a firm‘s market power.
A counter argument to this is that price discrimination might be a way of making a market more
contestable in the long run. For example, the low cost airlines have been hugely successful partly
on the back of extensive use of price discrimination among consumers to fill their planes.
Profits made in one market may allow firms to cross-
subsidise loss-making activities/services that have
important social benefits. For example money made
on commuter rail or bus services may allow transport
companies to support loss-making rural or night-time
services. Without the ability to price discriminate, these
services may have to be withdrawn and jobs might
suffer.
In many cases, aggressive price discrimination is seen
as inimical to business survival during a recession or
sudden market downturn.
An increase in total output resulting from selling extra
units at a lower price might help a monopoly to exploit economies of scale thereby reducing long
run average costs.
So what do you think about price discrimination? Is it a legitimate tactic to increase revenue and
profit? Or does it harm consumer welfare too much? One thing is for sure, it is pervasive
throughout every economy; it is a fact of life in markets where businesses, large and small, have
pricing power.
Suggestions for further reading on the economics of price discrimination
Price discrimination is a highly common tactic in all kinds of markets – here is a selection of articles
that cover the issue. The key evaluation issue is the question of who gains and who (if anyone)
loses from such pricing strategies. And whether government intervention is justified?
Cereal Killers (Tim Harford, Financial Times, November 2006)
Fair Trade or Foul (Tim Harford, April 2008)
Long-haul flights and price discrimination strategy at Ryanair (Rigotnomics Blog, June 2008)
Plenty of room at the Beijing Inn (Tutor2u blog July 2008)
Popcorn and price discrimination (Tutor2u blog, February 2008)
Price discrimination for Big Macs (Tutor2u blog, June 2008)

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Price discrimination on Priceline (The Pricing Blog, May 2008)
Product sabotage helps consumers (BBC online, Tim Harford, August 2007)
Revision on business pricing strategies (Tutor2u Blog, April 2008)
Tim Harford and the Secret Cappuccino (You Tube)
You Tell Us What Your Seat Is Worth (New York Times, July 2008)

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15. Monopoly and Economic Efficiency
In this section we evaluate the costs and benefits of businesses with industry muscle or monopoly
pricing power in markets. The standard economic and social case against monopolistic businesses
is no longer straightforward. Markets are changing all of the time and so are the conditions in which
businesses must operate regardless of whether they have any noticeable market power.
When a company lowers its price, is that genuine competition that benefits consumers or an
attempt to monopolise the market? If a company gains market share, is that a result of improved
efficiency or merely a competitive threat in the long run? When a company develops innovative
products that competitors cannot easily duplicate, is that monopolization? If several companies
look to limit excess output because of difficult trading conditions – is this necessarily collusive
behaviour that competition policy should look to stop?
The economic case against monopoly
The conventional textbook argument against market power is that monopolists can earn abnormal
(supernormal) profits at the expense of efficiency and the welfare of consumers and society.
The monopoly price is assumed to be higher than both marginal and average costs leading to a
loss of allocative efficiency and a failure of the market. The monopolist is extracting a price
from consumers that is above the cost of resources used in making the product and, consumers‘
needs and wants are not being satisfied, as the product is being under-consumed.
The higher average cost if there are inefficiencies in production means that the firm is not making
optimum use of scarce resources. Under these conditions, there may be a case for some form of
government intervention for example through the rigorous application of competition policy or by a
process of market deregulation (liberalisation).
X Inefficiencies under Monopoly
Output (Q)
Competitive Market Pure Monopoly
Price (P) Price (P)
Market
Supply
Market
Demand
Market
Supply
Monopoly
Demand
Q1 Q1
MR
P comp
P mon
Q2

77
The lack of genuine competition may give a monopolist less incentive to invest in new ideas or
consider the well-being of consumers. It can be argued that even if the monopolist benefits from
economies of scale, they have little incentive to control their costs and 'X' inefficiencies will mean
that there will be no real cost savings compared to a competitive market.
Adam Smith in An Inquiry into the Nature & Causes of Wealth of Nations (1776) "a monopoly is.
When a firm is able to charge excessive prices by deliberately keeping its market under stocked.‖
A competitive industry will produce in the long run where market demand = market supply.
Consider the diagrams below. Equilibrium output and price is at Q1 and Pcomp on the left hand
diagram and Pcomp and Q1 on the right hand diagram. At this point, Price = MC and the industry
meets the conditions for allocative efficiency.
If the industry is then taken over by a monopolist (not necessarily immediately!) the profit-
maximising point (MC=MR) is at price Pmon and output Q2. The monopolist is able to charge a
higher price restrict total output and thereby reduce welfare because the rise in price to Pmon
reduces consumer surplus. Some of this reduction in welfare is a pure transfer to the producer
through higher profits, but some of the loss is not reassigned to any other agent. This is known as
the deadweight welfare loss or the social cost of monopoly and is equal to the area ABC.
A similar result is seen in the next diagram which makes the assumption of constant long-run
average and marginal costs under both competition and monopoly. The deadweight loss of
welfare under monopoly (whose profit maximising price is P1 and Q1) is shown by the triangle
ABC. The competitive price and output is Pc and Qc respectively.
Output (Q)
Price (P)
Market
Supply
Market
Demand
Market
Supply
Monopoly
Demand
Q1 Q1
MR
P comp
P mon
Q2
Net loss of
consumer surplus
Net loss of
producer surplus
B
C
D
A
Price (P)

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Potential Benefits from Monopoly
A high market concentration (fewness of sellers) does not always signal the absence of
competition; sometimes it can reflect the success of leading firms in providing better quality
products, more efficiently, than their smaller rivals
One difficulty in assessing the welfare consequences of monopoly, duopoly or oligopoly lies in
defining precisely what a market constitutes! In nearly every industry a market is segmented into
different products, and globalization makes it difficult to gauge the degree of monopoly power.
So what are the main advantages of a market dominated by a few sellers?
Economies of Scale
A monopolist might be better positioned to exploit increasing returns to scale leasing to an
equilibrium which gives a higher output and a lower price than under competitive conditions. This is
illustrated in the next diagram, where we assume that the monopolist is able to drive marginal
costs lower in the long run, finding an equilibrium output of Q2 and pricing below the competitive
price.
LRAC = LRMC
Monopoly
Demand (AR)
MR
Q1
Monopoly Profit
at Price P1
Revenue
Cost and
Profit
Output (Q)
P1
Pc
Qc
B
A
C

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Monopoly Profits, Research and Development and Dynamic Efficiency
As firms are able to earn abnormal profits in the long run there may be a faster rate of
technological development that will reduce costs and produce better quality items for
consumers.
Monopoly power can be good for innovation. Despite the fact that the market leadership of firms
like Microsoft and Sony is often criticised, their investments in research and development (R&D)
can be beneficial to society because they expand the technological frontier and open new ways
to prosperity. Many innovations are developed by firms with patents on the ‗leading-edge‘
technologies.
Baumol – Oligopoly and Innovation
William Baumol an economist from Princeton University published a book titled ―The Free Market
Innovation Machine‖ in which he analysed the conditions best suited to achieve a faster pace of
innovation. Baumol argues that the structure that fosters productive innovation best is oligopoly.
The Baumol hypothesis is that oligopolists compete by making their products differ slightly from
their rivals. Highly innovative firms are often quick to license new technology or to become
members of technology-sharing consortia. (The UK digital boom, BBC news, August 2007)
Natural Monopoly
There are several interpretations of what a natural monopoly us
1. It occurs when one large business can supply the entire market at a lower price than two or
more smaller ones
2. A natural monopoly is a situation in which there cannot be more than one efficient provider
of a good. In this situation, competition might actually increase costs and prices
3. It is an industry where the minimum efficient scale is a large share of total market demand
such there is room for only one firm to fully exploit all of the available internal economies of
scale
4. An industry where the long run average cost curve falls continuously as output expands
Output (Q)
Price (P) Price (P)
Market
Supply
Market
Demand
Competitive
Supply
(MC)
Monopoly
Demand
Q1 Q1
MR
P comp
P mon
Q2
Monopoly
Supply with
Scale
Economies

80
Each of these definitions is linked. The key point is that a natural monopoly is characterized by
increasing returns to scale at all levels of output – thus the long run cost per unit (LRAC) will
drift lower as production expands. LRAC is falling because long run marginal cost is below LRAC.
This can be illustrated in the diagram below:
A natural monopoly occurs in an industry where LRAC falls over a large range of output levels
such that there may be room only for one supplier on their own to fully exploit all of the internal
economies of scale, reach the minimum efficient scale and achieve productive efficiency.
Because there is no single definition of a natural monopoly, none of the examples below are purely
national monopolies – but it is suggested that their cost structure does stake them close to a
common-sense interpretation:
1. British Telecom building and maintaining the UK telecommunications network for the
broadband industry – especially the ‗final mile‘ copper wiring from the local exchanges to
each household
2. The Royal Mail‟s postal distribution network – collection / sorting / delivery
3. Virgin Media owning and running the cable telecommunications network
4. Camelot operating the national network for the UK lottery
5. National Rail owning, maintaining and leasing out the UK rail network
6. National Grid plc which owns and operates the National Grid high-voltage electricity
transmission network in England and Wales. Since April 1, 2005 it also operates the
electricity transmission network in Scotland. Owns and operates the gas transmission
network (from terminals to distributors).
7. London Underground, Tyne and Wear Metro
8. National Air Traffic Services
An important point is that a natural monopoly does not mean that there is only one business
operating in the market or that only one firm can survive in the long run. Indeed there may be many
smaller businesses operating profitably in smaller ‗niche‘ segments of a market (however that is
defined).
Costs
Output
LRAC
LRMC
SRAC1
SRAC2

81
Possible conflicts between efficiency and welfare
It is often said that a natural monopoly raises difficult questions for competition policy because
On the one hand – it is more productively efficient for there to be one dominant provider
of a national infrastructure e.g. a rail network or electricity generating system
Natural monopolies often require enormous investment spending to maintain and improve
the networks e.g. who is going to pay for making our broadband network faster?
On the other hand – businesses with such deep-rooted monopoly power (huge barriers to
entry) might be tempted to exploit that market power by raising prices and making huge
supernormal profits – damaging consumer welfare
It is certainly true that to make profits, a natural monopolist will have to price well above the
marginal costs of supply – we can see that in the next diagram.
The profit-maximizing price is P1 at an output of Q1. Price is well above the marginal cost of
supply and high supernormal profits are made – but output is high too and there is still a sizeable
amount of consumer surplus because of the internal economies of scale that have brought down
the unit cost for all consumers. (We are ignoring the possibility of price discrimination here).
Options for competition policy in industries that resemble a natural monopoly
1. Nationalization: Bringing some of these industries into state ownership
a. Network Rail is a not-for-profit business (formerly Railtrack plc) – taken back into
public ownership in 2001
b. National Air Traffic Services – currently owned by the UK government (49%); The
Airline Group (42%) which is a consortium of British Airways, bmi, easyJet, Monarch
Airlines, Thomas Cook Airlines, Thomsonfly and Virgin Atlantic; BAA (4%); and
NATS employees (5%).
2. Price controls
Costs
Output
LRAC
LRMC
SRAC1
SRAC2
AR
MR
Q1
P1
C1

82
a. For many of the major utilities, the government introduced industry regulators to
oversee these businesses when they were privatized in the 1980s and early 1990s
b. For many years utility businesses such as British Telecom and British Gas were
subject to price capping– most of these have now finished although some remain –
for more details – see this link
3. Introducing competition into the industry -this has been a favoured policy
a. Basically involves separating out infrastructure from the final service to the
consumer – for example:
i. British Telecom was eventually forced to open-up local telecom exchanges
and allow other businesses in to install equipment (unbundling the local
loop) – who then sell services such as broadband to households –
competitors pay BT an access charge designed to give BT a 10% rate of
return from running the network
ii. National Rail runs the network – but train operating companies have to bid
for the franchise to run passenger services – and the industry regulator can
take their franchise away if the quality of service isn‘t good enough
iii. Camelot has successfully bid to operate the National Lottery until 2017
Case Study: BAA‟s Monopoly – Time to Head for the Departure Gate
Reviled by airlines complaining of high charges
and poor service and lambasted by passengers
furious about lost luggage and interminable
delays, the summer months have been
desperate for the British Airports Authority (BBA)
the owner and manager of Heathrow, Gatwick,
Stansted, Glasgow, Edinburgh, Aberdeen and
Southampton.
These seven airports account for 90% of the air
passengers using South East and East Anglian
airports and 84% of Scottish air passengers.
BAA racked up revenues of over £2bn in 2007
and an operating profit of close to £400m.
Nearly half of BAA's income came from aeronautical charges - including landing fees paid by
airlines for each flight. Over a quarter comes from their retail division and nine per cent comes from
property income. One per cent of income flows from other traffic charges – for example a charge of
£4.48 each time they use the Heathrow Taxi System. Add in the profits from expensive airport car
parking, profits from their stake in Heathrow Express, bureau de change businesses and duty free,
it is not hard to see how BAA is able to generate monopoly profits.
Enter the airlines, many of whom have complained bitterly about the quality of service and the cost
of operating at BAA's airports. British Airways claims that "BAA‘s record at Heathrow has been
lamentable and common ownership is the root cause of the failure to expand Heathrow‘s runway
capacity.‖ Ryanair, easily the most outspoken of all of the low-cost carriers is reported as saying
that "―Heathrow is a mess, passengers continue to be stuck in long security queues at Stansted
and Gatwick‘s development is being held back by this over charging monopoly. We call on the
Competition Commission to force a break-up of this abusive monopoly as soon as possible.‖
BAA has mounted a robust defence of its position claiming that "common ownership has yielded
benefits for consumers and remains the best structure for the efficient operation of airports – the
most important issue for passengers.‖ BAA argues that it has ―invested in major new facilities‖ and

83
that the major problem is that UK airport terminals are already running at maximum capacity.
Grupo Ferrovial, the Spanish owners of BAA has defended BAA as a natural monopoly with the
three major London airports together competing with other global transport hubs.
A second strand of defence from BAA is that the airports they run now have been starved of
investment in the past and this affects their current performance. They claim that regulatory control
from the Civil Aviation Authority (CAA) is damaging. BAA is committed to investing more than
£9.5bn upgrading the three airports over the next 10 years. But the CAA is proposing to lower the
cap on investment returns, to 6.2 per cent from 7.75 per cent, a disincentive to go ahead with multi-
billion dollar capital projects?
A counter argument is BAA has an effective rather than a natural monopoly and that BAA gains
more from the spill-over effects that flow from passenger demand exceeding the capacity at
Heathrow. Airlines and their passengers are more or less forced to switch to Gatwick and/or
Stansted because Heathrow is completely chocker! Monopoly power can lead to X-inefficiencies,
higher prices and lower levels of innovation. The passenger experience deteriorates but there is
little that they can do about it.
In August 2008, the Competition Commission issued a report arguing that BAA may have to sell
three of its seven UK airports because of concerns about its market dominance.
Source: Geoff Riley, EconoMax, September 2007
MPs call for BAA to be broken up (BBC news, March 2008)
BAA to raise airport landing fees (BBC news, March 2008)
The future of Britain‘s airports (BBC news, August 2008)
Suggestions for further reading on monopoly and economic efficiency and welfare
In all of these examples we are dealing with businesses that have substantial market power – each
industry needs to be judged on a case by case basis – have a read through some of these articles
and consider whether there are grounds for arguing that monopoly power is having a negative
effect on consumer welfare.
EU fines Microsoft £680m 'to close dark chapter' in fight against monopoly (Guardian, Feb 2008)
Gaviscon maker cheated the NHS (Newsnight, March 2008)
Glaxo unveils plans to diversify (BBC news, July 2008)
Have supermarkets become too powerful? (Independent, September 2007)
MEP demands city parking inquiry (BBC news, August 2007)
Mexican pledge to tackle monopoly power (Financial Times, May 2008)
Murdoch versus the Evening Standard – competition in free newspapers (BBC, September 2006)
Open skies deal comes into effect (BBC news, March 2008)
Paying for music downloads is like buying air (The Times, July 2008)
Probe into BAA airport monopoly (BBC News, June 2006)
Supermarkets admit milk price fix (BBC news, December 2007)
The chewing gum war (BBC Money Programme, May 2007)

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16. Collusive and Non-Collusive Oligopoly
What is an oligopoly?
An oligopoly is a market dominated by a few
producers. An oligopoly is an industry where there is a
high level of market concentration. Examples of
markets that can be described as oligopolies include the
markets for petrol in the UK, soft drinks producers and
the major high street banks. Another example is the
global market for sports footwear – 60% of which is held
by Nike and Adidas.
However, oligopoly is best defined by the conduct (or
behaviour) of firms within a market.
The concentration ratio measures the extent to which a
market or industry is dominated by a few leading firms.
Normally an oligopoly exists when the top five firms in the market account for more than 60% of
total market sales.
Characteristics of an oligopoly
There is no single theory of price and output under conditions of oligopoly. If a price war breaks
out, oligopolists may choose produce and price much as a highly competitive industry would;
whereas at other times they act like a pure monopoly.
An oligopoly usually exhibits the following features:
1. Product branding: Each firm in the market is selling a branded product.
2. Entry barriers: Entry barriers maintain supernormal profits for the dominant firms. It is
possible for many smaller firms to operate on the periphery of an oligopolistic market, but
none of them is large enough to have any significant effect on prices and output
3. Inter-dependent decision-making: Inter-dependence means that firms must take into
account the likely reactions of their rivals to any change in price, output or forms of non-
price competition.
4. Non-price competition: Non-price competition is a consistent feature of the competitive
strategies of oligopolistic firms.
Duopoly
Duopoly is a form of oligopoly. In its purest form two firms control all of the market, but in reality
the term duopoly is used to describe any market where two firms dominate with a significant
market share. There are many examples of duopoly; including Coca-Cola and Pepsi (soft drinks),
Unilever and Proctor & Gamble (detergents), Sotheby‘s and Christie‘s (auctioneers of
antiques/paintings), Standard and Poor‘s and Moody‘s (credit rating agencies), BSkyB and Setanta
(live Premiership football), and Airbus and Boeing (aircraft manufacturers).

85
In these markets entry barriers are high although there are usually smaller players in the market
surviving successfully such as Virgin Cola. However, if it had not been for the European
Competition Commission Sky‘s monopoly in the market for live television coverage of Premiership
football in the UK would have continued. The high entry barriers in duopolies are usually based on
one or more of the following: brand loyalty, product differentiation and huge research economies of
scale.
Source: Adapted from Robert Nutter, EconoMax, October 2007
Kinked Demand Curve Model of Oligopoly
The kinked demand curve model assumes that a business might face a dual demand curve for its
product based on the likely reactions of other firms to a change in its price or another variable.
The common assumption is that firms in an oligopoly are looking to protect and maintain their
market share and that rival firms are unlikely to match another‟s price increase but may
match a price fall. I.e. rival firms within an oligopoly react asymmetrically to a change in the price
of another firm.
If a business raises price and others leave their prices constant, then we can expect quite a
large substitution effect making demand relatively price elastic. The business would
then lose market share and expect to see a fall in its total revenue.
If a business reduces its price but other firms decide to follow suit, the relative price
change is smaller and demand would be inelastic. Cutting prices when demand is inelastic
also leads to a fall in total revenue with little or no effect on market share.
The kinked demand curve model makes a
prediction that a business might reach a
stable profit-maximising equilibrium at
price P1 and output Q1 and have little
incentive to alter prices.
Assume we start out at P1 and Q1:
Will a firm benefit from raising price
above P1?
Will it benefit from cutting price below
P1?
Raising price above P1
Demand is relatively elastic because
other firms do not match a price rise
Firm loses market share and some total
revenue
Reducing price below P1
Demand is relatively inelastic
Little gain in market share – other firms
have followed suit in cutting prices
Total revenue may still fall
Costs
Revenues
Output (Q)
P1
Q1
MR
AR

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The kinked demand curve model predicts there will be periods of relative price stability under an
oligopoly with businesses focusing on non-price competition as a means of reinforcing their
market position and increasing their supernormal profits. Short-lived price wars between rival firms
can still happen under the kinked demand curve model. During a price war, firms in the market are
seeking to snatch a short term advantage and win over some extra market share.
Recent examples of price wars include the major UK supermarkets, price discounting of computers
in China and a price war between cross channel speed ferry services. Price competition is
frequently seen in the telecommunications industry.
Changes in costs using the kinked demand curve analysis
One prediction of the kinked demand curve model is that changes in variable costs might not lead
to a rise or fall in the profit maximising price and output. This is shown in the next diagram where it
is assumed that a rise in costs such as energy and raw material prices leads to an upward shift in
the marginal cost curve from MC1 to MC2. Despite this shift, the equilibrium price and output
remains at Q1. It would take another hike in costs to MC3 for the price to alter.
There is limited real-world evidence for the kinked demand curve model. The theory can be
criticised for not explaining why firms start out at the equilibrium price and quantity. That said it is
one possible model of how firms in an oligopoly might behave if they have to consider the likely
responses of their rivals.
The importance of non-price competition under oligopoly
Non-price competition assumes increased
importance in oligopolistic markets. This involves
advertising and marketing strategies to increase
demand and develop brand loyalty among consumers.
Businesses will use other policies to increase market
share:
Output (Q)
P1
Q1
MR
AR
MC1
MC2
MC3
Increase in marginal cost
from MC1 to MC2 does not
lead to a change in the profit
maximising price and output
P2
Q2
Increase in marginal cost from
MC2 to MC3 does lead to a
change in output and price
Price (P)

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o Better quality of service including guaranteed delivery times for consumers and low-cost
servicing agreements.
o Longer opening hours for retailers, 24 hour online customer support.
o Discounts on product upgrades when they become available in the market.
o Contractual relationships with suppliers - for example the system of tied houses for
pubs and contractual agreements with franchises (offering exclusive distribution
agreements). For example, Apple has signed exclusive distribution agreements with T-
Mobile of Germany, Orange in France and O2 in the UK for the iPhone. The agreements
give Apple 10 percent of sales from phone calls and data transfers made over the devices.
Advertising spending runs in millions of pounds for many firms. Some simply apply a profit
maximising rule to their marketing strategies. A promotional campaign is profitable if the marginal
revenue from any extra sales exceeds the cost of the advertising campaign and marginal costs of
producing an increase in output. However, it is not always easy to measure accurately the
incremental sales arising from a specific advertising campaign. Other businesses see advertising
simply as a way of increasing sales revenue. If persuasive advertising leads to an outward shift
in demand, consumers are willing to pay more for each unit consumed. This increases the potential
consumer surplus that a business might extract.
Relatively high spending on marketing is important for new business start-ups (consider the huge
and often extravagant sums spent on marketing by the emerging dot-coms during the internet
mania of the late 1990s and into 2000) and also by firms trying to break into an existing market
where there is consumer or brand loyalty to the existing products in the market.
Price Collusion in Oligopoly
Collusive behaviour is thought to be a common feature of many oligopolistic markets. In this
section we look at different forms of collusion starting with tacit collusion based around price
leadership.
Tacit collusion
Price leadership refers to a situation where prices and price changes established by a dominant
firm, or a firm are usually accepted by others and which other firms in the industry adopt and
follow. When price leadership is adopted to facilitate tacit (or silent) collusion, the price leader will
generally tend to set a price high enough that the least cost-efficient firm in the market may earn
some return above the competitive level.
We see examples of this with the major mortgage lenders and petrol retailers where many
suppliers follow the pricing strategies of leading firms. If most firms in a market are moving prices
in the same direction, it can take some time for relative price differences to emerge which might
cause consumers to switch their demand.
Firms who market to consumers that they are ―never knowingly undersold‖ or who claim to be
monitoring and matching the cheapest price in a given geographical area are essentially engaged
in tacit collusion. Does the consumer really benefit from this? Tim Harford‘s article ―Match me if
you Can‖ in February 2007 is especially worth reading on this pricing strategy.
Tacit collusion occurs where firms undertake actions that are likely to minimise a competitive
response, e.g. avoiding price cutting or not attacking each other‘s market
It is often observed that when a market is dominated by a few large firms, there is always the
potential for businesses to seek to reduce uncertainty and engage in some form of collusive
behaviour. When this happens the existing firms engage in price fixing cartels. This behaviour is

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deemed illegal by UK and European competition law. But it is hard to prove that a group of firms
have deliberately joined together to raise prices.
Case Study: Tacit Price Collusion in the UK Energy Market?
There has been concern for some time that the UK retail energy sector has become consolidated
into dominance by only six major companies - an oligopoly. The six companies with the major
market shares are British Gas, Scottish and Southern Energy, EDF, E.ON, ScottishPower and
nPower who also are the members of the Energy Retail Association (ERA). The meetings of the
ERA have been seen by groups such as Energywatch as a cartel where prices are fixed to boost
the members‘ profits.
Industry insiders believe that the ERA meetings have resulted in member companies‘ prices of gas
and electricity rising in step within a few weeks of each other. A few large companies selling a
homogeneous product which is price inelastic in demand has all the makings of a cartel. The big
energy suppliers have become increasingly vertically integrated in recent years, both generating
and retailing gas and electricity.
There may well be no cartel but rather a complex monopoly in which an oligopoly may not actually
collude but the outcome in the market suggests that they have.
Source: Robert Nutter, EconoMax, October 2007
Explicit Price Fixing
Collusion is often explained by a desire to achieve joint-profit maximisation within a market or
prevent price and revenue instability in an industry. Price fixing represents an attempt by suppliers
to control supply and fix price at a level close to the level we would expect from a monopoly.
To collude on price, producers must be able to exert some control over market supply. In the
diagram below a producer cartel is assumed to fix the cartel price at price Pm. The distribution of
the cartel output may be allocated on the basis of an output quota system or another process of
negotiation.
Although the cartel as a whole is maximising profits, the individual firm‘s output quota is unlikely to
be at their profit maximising point. For any one firm, expanding output and selling at a price that
slightly undercuts the cartel price can achieve extra profits! Unfortunately if one firm does this, it is
in each firm‘s interests to do exactly the same and, if all firms break the terms of their cartel
agreement, the result will be excess supply in the market and a sharp fall in the price. Under these
circumstances, a cartel agreement can break down.

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Collusion in a market or industry is easier to achieve when:
1. There are only a small number of firms in the industry and barriers to entry protect the
monopoly power of existing firms in the long run.
2. Market demand is not too variable (or cyclical) i.e. it is reasonably predictable and not
subject to violent fluctuations which may lead to excess demand or excess supply.
3. Demand is fairly inelastic with respect to price so that a higher cartel price increases the
total revenue to suppliers – this is easier when the product is viewed as a necessity.
4. Each firm‟s output can be easily monitored (this is important!) – This enables the cartel
more easily to control total supply and identify firms who are cheating on output quotas.
5. Incomplete information about motivation of other firms may induce tacit collusion.
Possible break-downs of cartels
Most cartel arrangements experience difficulties and tensions and some cartels collapse
completely. Several factors can create problems within a collusive agreement between suppliers:
1. Enforcement problems: The cartel aims to restrict production to maximize total profits of
members. But each individual seller finds it profitable to expand production. It may become
difficult for the cartel to enforce its output quotas and there may be disputes about how to
share out the profits. Other firms – not members of the cartel – may opt to take a free ride
by producing close to but just under the cartel price.
2. Falling market demand creates excess capacity in the industry and puts pressure on
individual firms to discount prices to maintain their revenue. There are good recent
examples of this in commodity markets including the collapse of the coffee export cartel.
3. The successful entry of non-cartel firms into the industry undermines a cartel‘s control
of the market – e.g. the emergence of online retailers in the book industry in the mid 1990s
led ultimately to the end of the Net Book Agreement in 1995.
4. The exposure of illegal price fixing by market regulators such as UK Office of Fair
Trading.
Exposure of cartels within the European Union and the USA
Individual Firm inside the Cartel Industry Costs and Revenues
Firms Output Industry Output
MC (industry)
Demand
MR
MC
AC
Quota Industry
Output (Qm)
Pm (cartel)
Pm (cartel)
Price Price

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In recent years a substantial number of price-fixing agreements have been uncovered by the
European Union, UK and USA competition authorities. Some of the most prominent examples can
be explored by using the links below:
Law broken on pricing by tobacco firms (2008)
Airlines fined $504m in US air-cargo price fixing probe (2008)
BA given massive fine for fuel surcharge price fixing (2007)
How arch rivals colluded to hike up cost of air travel (2007)
Supermarkets fined £116m for dairy price-fixing (2007)
Dutch brewing cartel (2007)
Lift manufacturers cartel (2007)
Rubber cartel (2007)
Chemicals price fixing cartel (2006)
Copper price fixing cartel (2006)
Lift companies cartel (2005)
Plastics bags cartel (2005)
Sotheby‘s fined £12m for price fixing (2002)
More recent articles on collusion are available from the Tutor2u blog.
17. Oligopoly and Game Theory
In brief, game theory is about making predictions about another person's actions. In this chapter
we provide an introduction to game theory and consider some areas where lessons from game
theory can be applied by economist from climate change negotiations to the incentives to engage
in crime!
The Monty Hall problem!
Suppose you‘re on a game show, and you‘re given the choice of three doors. Behind one door is a
car, behind the others, goats. You pick a door, say number 1, and the host, who knows what‘s
behind the doors, opens another door, say number 3, which has a goat. He says to you, ―Do you
want to pick door number 2?‖ Is it to your advantage to switch your choice of doors?
Possible answer to the Monty Hall problem
Game Theory
Game theory is mainly concerned with predicting the outcome of games of strategy in which the
participants (for example two or more businesses competing in a market) have incomplete
information about the others' intentions.
Game theory analysis has direct relevance to the study of the conduct and behaviour of firms in
oligopolistic markets – for example the decisions that firms must take over pricing, and how much
money to invest in research and development spending. Costly research projects represent a risk
for any business – but if one firm invests in R&D, can a rival firm decide not to follow? They might
lose the competitive edge in the market and suffer a long term decline in market share and
profitability. The dominant strategy for both firms is probably to go ahead with R&D spending. If
they do not and the other firm does, then their profits fall and they lose market share. However,
there are only a limited number of patents available to be won and if all of the leading firms in a
market spend heavily on R&D, this may ultimately yield a lower total rate of return than if only one
firm opts to proceed.
The Prisoners‟ Dilemma

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The classic example of game theory is the
Prisoners‘ Dilemma, a situation where two
prisoners are being questioned over their guilt or
innocence of a crime. They have a simple choice,
either to confess to the crime (thereby implicating
their accomplice) and accept the consequences, or
to deny all involvement and hope that their partner
does likewise.
Confess or keep quiet? The Prisoner’s Dilemma is
a classic example of basic game theory in action!
The ―pay-off‖ is measured in terms of years in
prison arising from their choices and this is summarised in the table below. No communication is
permitted between the two suspects – in other words, each must make an independent decision,
but clearly they will take into account the likely behaviour of the other when under interrogation.
―When I am getting ready to reason with a man I spend one-third of my time thinking about myself
and what I am going to say, and two-thirds thinking about him and what he is going to say.‖
Source: Abraham Lincoln
Here is an example of the Prisoners‘ Dilemma:
Two prisoners are held in a separate room
and cannot communicate
They are both suspected of a crime
They can either confess or they can deny the
crime
Payoffs shown in the matrix are years in
prison from their chosen course of action
Prisoner A
Confess Deny
Prisoner B
Confess (3 years, 3 years) (1 year, 10 years)
Deny (10 years, 1 year) (2 years, 2 years)
What is the best strategy for each prisoner? Equilibrium happens when each player takes
decisions which maximise the outcome for them given the actions of the other player in the game.
In our example of the Prisoners‘ Dilemma, the dominant strategy for each player is to confess
since this is a course of action likely to minimise the average number of years they might expect to
remain in prison. But if both prisoners choose to confess, their ―pay-off‖ i.e. 3 years each in prison
is higher than if they both choose to deny any involvement in the crime.
That said, even if both prisoners chose to deny the crime (and indeed could communicate to agree
this course of action), then each prisoner has an incentive to cheat on any agreement and
confess, thereby reducing their own spell in custody.
The equilibrium in the Prisoners‘ Dilemma
occurs when each player takes the best Prisoner A

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possible action for themselves given the
action of the other player.
The dominant strategy is each prisoners‘
unique best strategy regardless of the other
players’ action
Best strategy? Confess?
A bad outcome! – Both prisoners could do
better by both denying – but once collusion
sets in, each prisoner has an incentive to
cheat! Confess Deny
Prisoner B
Confess (3 years, 3 years) (1 year, 10 years)
Deny (10 years, 1 year) (2 years, 2 years)

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Applying the Prisoner‟s Dilemma to business decisions
Game theory examples usually revolve around the pay-offs that come from making different
decisions. One arrangement of possible payoffs is as follows:
T refers to the temptation to defect
R refers to the reward for mutual cooperation between players
P refers to the punishment for mutual defection
S refers to the sucker‘s payoff
In the classic prisoner‘s dilemma the reward to defecting is greater than mutual cooperation which
itself brings a higher reward than mutual defection which itself is better than the sucker‘s pay-off.
And critically, the reward for two players cooperating with each other is higher than the average
reward from defection and the sucker‘s pay-off.
Consider this example of a simple pricing game: The values in the table refer to the profits that flow
from making a particular decision.
Firm B‟s output
High output Low output
Firm A‟s output
High output £5m, £5m £12m, £4m
Low output £4m, £12m £10m, £10m
Display of payoffs: row first, column second e.g. if Firm A chooses a high output and Firm B opts
for a low output, Firm A wins £12m and Firm B wins £4m.
In this game the reward to both firms choosing to limit supply and thereby keep the price relatively
high is that they each earn £10m. But choosing to defect from this strategy and increase output
can cause a rise in market supply, lower prices and lower profits - £5m each if both choose to do
so.
A dominant strategy is a strategy that is best irrespective of the other player‘s choice. In this case
the dominant strategy is competition between the firms.
Game theory analysis has direct relevance to our study of the behaviour of businesses in
oligopolistic markets – for example the decisions that firms must take over pricing of products, and
also how much money to invest in research and development. Costly research projects represent a
risk for any business – but if one firm invests in R&D, can another rival firm decide not to follow?
They might lose the competitive edge in the market and suffer a decline in market share and
profitability.
The dominant strategy for both firms is probably to go ahead with R&D spending. However, there
are only a limited number of patents available to be won and if all of the leading firms in a market
spend heavily on R&D, this may ultimately yield a lower total rate of return than if only one firm
opts to proceed.
The Prisoners‟ Dilemma can help to explain the break down of price-fixing agreements between
producers which can lead to the out-break of price wars among suppliers, the break-down of other
joint ventures between producers and also the collapse of free-trade agreements between
countries when one or more countries decides that protectionist strategies are in their own best
interest.
The key point is that game theory provides an insight into the interdependent decision-making
that lies at the heart of the interaction between businesses in a competitive market.

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Case Study: Claims of Price Rigging in the Food Industry
There is plenty for the consumer to feel
irked about as the cost of food, petrol and
other essential basics seems to race
ahead of the general rate of inflation. Yet
now it seems there is a conspiracy among
some large companies to fix the price of
other goods we buy, such as toothpaste
and shampoo.
There is currently an OFT investigation into
the pricing behaviour of some big name
companies - Proctor and Gamble, Coca-
Cola, Kimberly-Clark, GlaxoSmithKline and
Unilever. The leading supermarkets –
Tesco, Sainsbury, Asda and Morrisons
have also received visits by OFT
investigators. What these large companies
have in common is that economists would classify them as oligopolies (industries where there are
a small number of large firms). These businesses can behave in the following ways as economic
theory predicts:
Prices are sticky – by expecting the worst, firms are most likely to choose non-price
competition. If a firm is considering a price rise, the worst outcome would be if the other
firms in the industry do not increase their prices, causing the firm to lose business.
Therefore the firm will be reluctant to raise prices. If a firm is considering reducing its price,
the worst outcome is if all the other firms also choose to cut prices. The firm will not gain
market share, but will end up with less revenue. Therefore the firm will be reluctant to
decrease its price, all other things being equal. So firms will, instead, use methods of non-
price competition such as ‗buy one, get one free‘, ‗3 for 2‘ offers, free gifts, loyalty points,
etc. Firms are likely to spend large amounts on advertising designed to establish brand
loyalty.
Price wars – sometimes an oligopoly will make an aggressive move to try and win market
share. The big name supermarkets do this from time to time. One firm cuts prices
significantly and others follow or undercut so as not to lose their share. This can be a good
outcome for consumers, but does not appear to be happening at present.
Collusion – this is where the firms choose to act together to ‗fix‘ prices and can be illegal.
However, some collusive behaviour is hard to pin down, which is why an OFT investigation
is going ahead. If costs of production increase, it is not unreasonable to expect all firms in
the industry to respond with an increase in price, but there appears to be some evidence,
for example, that supermarkets have used rising costs as an excuse to inflate their prices to
increase profit margins.
If it does transpire that some of the best known companies have been acting illegally by price
fixing, this will look very bad for them at a time when consumers are already feeling the pinch.
Source: Liz Veal, EconoMax, June 2008

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Case Study: Prisoner's Dilemma and Climate Change Negotiations
Can repeated games of the prisoner‘s dilemma help
climate negotiations?
With 2012 signalling the expiry date of the Kyoto
Protocol, there is an urgent need for a successor
treaty to tackle the ever-increasing global emissions
problem. The main issue with tackling climate change
is the cost to countries of implementing it. To be
successful it will need profound transformation of
energy and transport organisations, and changes in
the behaviours of billions of consumers. The Stern
Review admitted that it will likely cost 1% of GDP –
even though it doesn‘t seem much, it is double the
amount currently spent on development aid
worldwide.
The USA sees a cap on carbon emissions as a threat to competitiveness, and hence to its
global supremacy;
The developing world denounces any calls for a cap on emissions as an effort by former
colonial powers to hold back development;
Europe has been making encouraging though patchy progress towards targets, driven
mainly by a one-off switch from coal to gas.
The issue here is how countries can expect to make cuts in emissions when their economic
competitors refuse. This in turn leads to the Tragedy of the Commons which occurs when a
group‘s individual incentive lead them to take actions which, overall, lead to negative
consequences for all group members.
A country that refuses to act, whilst the other cooperates, will experience a free-rider benefit -
enjoying the advantage of limited climate change without the cost. On the flip side, any country that
imposes limits, when its competitors do not, incurs not just the cost of limiting its own emissions,
but also a further cost in terms of reduced competitiveness
The dynamics of the prisoner‘s dilemma do change if participants know that they will be playing the
game more than once. In 1984 an American political scientist at the University of Michigan, Robert
Axelrod, argued that if you play the game repeatedly you are likely to see emerging is cooperative
rather than defective actions. He identified four elements to a successful strategy which is this case
can be applied to climate negotiations:
1. Be Nice – sign up to unilateral cuts in emissions, as deep as your economy and financing
capacity allows.
2. Be Retaliatory – single out countries that have not commenced action and, in
collaboration, find ways of pressurising them until they do so.
3. Be Forgiving - when non-compliant countries come onboard give them generous
applause; signal that good behaviour will be rewarded with even deeper cuts in your own
emissions.
4. Be Clear - let everyone know in advance exactly how you are going to behave – that you
will work with them if they take action on emissions, and that you will retaliate if they do not.
Repeated Prisoner‘s Dilemma provides valuable insight into how countries should act away from
the negotiating table and over the longer term. Ultimately, for the planet‘s sake, one hopes that
everyone will play the game

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Source: Mark Johnston, EconoMax, December 2007
John Maynard Keynes‟ “The Beauty Contest”:
―...professional investment may be likened to those newspaper competitions in which the
competitors have to pick out the six prettiest faces from a hundred photographs, the prize being
awarded to the competitor whose choice most nearly corresponds to the average preferences of
the competitors as a whole; so that each competitor has to pick, not those faces which he himself
finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of
whom are looking at the problem from the same point of view. It is not a case of choosing those
which, to the best of one‘s judgment, are really the prettiest, nor even those which average opinion
genuinely thinks the prettiest.
We have reached the third degree where we devote our intelligences to anticipating what average
opinion expects the average opinion to be.‖
Source: J.M. Keynes; General Theory, p.156, 1936
Suggestions for further reading on game theory
Game theory resources (US based site) www.gametheory.net/
Game theory society (US based site) www.gametheorysociety.org/
Prisoners Dilemma and a Big Brother Housemates Game! http://www.paulspages.co.uk/hmd/
Do economists need brains? (The Economist, July 2008)
Game of co-operation and betrayal
Game theory and the Dark Knight (Pure Pedantry Blog, July 2008)
Game theory could save the world (Telegraph, July 2008)
Reaping rewards for cheating (Sydney Morning Herald, July 2008)
Supermarket petrol price cuts (BBC news, July 2008)
Under the hammer – auctions and game theory (Tim Harford, May 2007)
World Cup Game Theory (Tim Harford, Slate, July 2006)
World trade talks collapse over tariff protection (Guardian, July 2008)
Suggestions for further reading on oligopoly
Call to investigate energy 'oligopolies' (Guardian, May 2008)
Collapse of the DOHA trade negotiations – free trade versus protectionism (BBC news, July 2008)
Comfortable power oligopoly ripping off customers (The Times, May 2008)
OPEC cartel‘s empty tool kit (Fortune Magazine, July 2008)
Tescopoly website
Thai cartel idea outrages rice consumers (Times, May 2008)
Top Paris hotels guilty of price fixing (Times, November 2005)
Wake up to old-fashioned power of new oligopolies (Financial Times, February 2006)

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18. Contestable Markets
There has been a wealth of research and
interest in the idea of market contestability in
recent years, this chapter considers the nature
of a contestable market, the barriers to
competition and how contestability can affect the
behaviour of businesses in the market-place.
What is a contestable market?
William Baumol defined contestable markets as
existing where
“An entrant has access to all production techniques available to the incumbents, is not prohibited
from wooing the incumbent’s customers, and entry decisions can be reversed without cost.”
For a contestable market to exist there must be low barriers to entry and exit so new suppliers to
come into a market to provide fresh competition. For a perfectly contestable market, entry into and
exit out must be costless
The reality is that no market is perfectly contestable but it is also true that virtually every
market is contestable to some degree even when it appears that the monopoly position of a
dominant seller is unassailable. This can have implications for the behaviour (conduct) of existing
firms and then affects the performance of a market in terms of allocative, productive and
dynamic efficiency.
Contestable markets and perfect competition - the differences
Contestable markets are different from perfect competitive markets. For example, it is feasible in a
contestable market for one firm to have price-setting power and for firms in a market to produce
a differentiated product.
There are three main conditions for pure market contestability:
o Perfect information and the ability and/or the right of all suppliers to make use of the best
available production technology in the market.
o The freedom to market / advertise and enter a market with a competing product.
o The absence of sunk costs – this reduces the risks of coming into a market.
Sunk costs – a barrier to contestability
Barriers to market contestability exist when there are sunk costs. These are costs that have
been committed by a business cannot be recovered once a firm has entered the industry. It
might be easier to think of sunk costs as costs that are unavoidable once they have been
committed at a particular moment in time – a classic example being the money that the telecoms
firms committed to winning the 3rd
generation mobile phone licences at auction in 2000.
The Increasing Contestability of Markets
One feature of the British and European economy in recent years has been an increase in the
number of markets and industries that are genuinely contestable. Several factors explain this
development:
1. Entrepreneurial Zeal: It is often the case that markets become more competitive because
of the persistence of entrepreneurs who simply do not accept that the existing market

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structure is a given. A new supplier may have the advantage of product innovation or a
more competitive business model based on different pricing strategies.
2. De-regulation of markets – De-regulation involves the opening up of markets to
competition by reducing some of the statutory barriers to entry that exist. Good
examples of recent deregulation include the liberalisation of telecommunications and postal
services as part of the European Union competition initiatives. And also the Open Skies
initiative in aviation that is aimed at opening up trans-Atlantic air travel.
3. Competition Policy: Tougher competition laws acting against predatory behaviour by
existing firms are designed to make markets more contestable. In both the UK and the EU
this has included tougher rules against price fixing cartels. When market contestability is
weak, there is nearly always greater scope for cartel-type behaviour by the existing firms,
particularly if the market structure in which they operate comes close to an oligopoly.
4. The European Single Market: The development of the Single European Market has
opened up the markets for member nations. A good example of this is home and car
insurance and also the entry of Western European clothes retailers onto the UK high
streets and shopping malls. The abolition of block-exemption for car dealerships within the
EU should also help to make the retail car market more contestable in the UK in particular
and may help to bring down further the prices of new cars.
5. Technological Change (including the e-mergence of e-commerce): The impact of new
technology is having a huge effect, not least because it have brought down some of the
entry costs in some markets (leading to an increase in capital mobility). The rapid
expansion of e-commerce for example has lead to the emergence of new players in the
travel sector and online bookselling, insurance and many other markets.
6. Technological spill-over can lead to the development of rival products that copy or imitate
the characteristics of the products of the incumbent firms. Just a few years after the launch
of Viagra, the anti-impotence drug, Levitra, the first market rival to the hugely profitable
Viagra, is now being manufactured by the German firm, Bayer AG, and marketed by the
British firm GlaxoSmithKline.
Case Study - The Global Credit and Debit Card Market
In the spring of 2008 Visa floated on the US stock market in an $18 billion initial public offering, the
largest in the United States and following hot on the heels of the stock 2006 market debut for
Visa‘s main rival MasterCard.
The two businesses are locked in a fierce battle for market share. Currently Visa has 55% of the
world‘s payments cards and a 59% slice of total transactions. MasterCard has 36% of cards and
31% of the value of transactions. Simple maths tells us that this is a good example of a duopoly –
there are other players notably American Express and Diners Club, but they are in a completely
different league. If anything, Visa and MasterCard‘s main competitors are cash and cheques!
The key to understanding this level of market dominance is the concept of a platform (or network)
economy of scale. The fixed costs of building, maintaining and expanding a payments system are
enormous but the marginal costs of adding one more user to the system are, in contrast, tiny
Over the years, Visa has built a large retail payments network with commercial relationships with
nearly 17,000 financial institutions and 30 million retail outlets – making it easily the world‘s biggest
payments system. There are over 1.5 billion Visa cards in issue and around 1 billion transactions
are made annually. Visa has more cards in circulation than all the major competitors combined and
their cards are accepted in 170 countries or territories. In Western Europe alone, nearly 350 million
Visa cards are now in circulation. 11.4% of consumer spending at point of sale in Europe is with a
Visa card. At Christmas in 2007, the Visa network was handling 7,400 messages per second and
their system has a capacity to cope with upwards of 12,000 before reaching a ceiling.

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The Visa brand has been extended in many different ways to exploit economies of scope - from
basic ATM cash cards, through to debit and credit cards targeted at different segments of the
payments market. Take your choice from Visa Classic, Visa Gold, Visa Platinum, Visa Infinite, Visa
Electron, PLUS and Visa Travellers Cheques and V-Pay!
Because of the investment in infrastructure and the internal economies of scale from adding
more merchant outlets and extra customers, Visa estimates that the average cost per transaction
has fallen by nearly a half over the last five years – this is a hugely important competitive
advantage for the business going forward
Of course this has not stopped regular accusations that Visa has engaged in anti-competitive
practices as a barrier to entry in a highly profitable global industry. In 2007, American Express
claimed that Visa and others had prevented 20,000 US banks from using Amex credit card
products. Earlier this year, American Express accepted a payment of £1bn from Visa to settle the
dispute and have Visa dropped as a defendant in the anti-trust case. Other critics of Visa and
MasterCard claim that the high charges for using cards represent a ‗tax on consumption‘ that hit
the poorest hardest.
And this year a cluster of leading European banks including Commerzbank, Deutsche Bank,
Société Générale and BNP Paribas has been giving serious consideration to setting up a rival
network to Visa and MasterCard. Can they overcome the barriers to entry and make a profitable
entry into this market?
Source: EconoMax, May 2008
How does the threat of competition affect a firm‟s behaviour?
How might the contestability of a market affect the conduct and performance of businesses? It is
worth emphasising in essays and data questions that it is the actual behaviour of agents in the
market that is more important that a simple picture of market share.
In the diagram above a pure monopoly might price at P1 – the profit maximising equilibrium. If a
market is contestable, there is downward pressure on price, because the presence supernormal
profits signals for new firms to enter the market and if the existing monopolist is producing at too
high a price or has allowed their average total costs to drift higher, then entrants can undercut the
Costs
Revenues
Output (Q)
AC
AR (Monopoly)
MR
MC
Q1
P1
Profit Max at
Price P1
P2
Q2

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monopolist and some of the abnormal profit will be competed away. Normal profit equilibrium
occurs when average revenue equals average total cost (at output Q2 and price P2). A lower price
and higher output causes an increase in consumer surplus.
When markets are contestable – we expect to see lower profit margins than when a monopoly
operates without competition. Indeed the threat of competition may be just as powerful an
influence on the behaviour of the existing firms in a market than the actual entry of new
businesses. If a dominant firm in a contestable market knows that new suppliers may come in –
this may be sufficient for them to charge a price closer to the level we might expect from a
competitive market structure.
If a market is contestable, industry structure and firm behaviour is determined by the threat of
competition - 'hit-and-run' entry. The market will resemble perfect competition, regardless of the
number of firms, since incumbents behave as if there were intense competition.
Market Contestability in Online Music
iTunes has overtaken Walmart as the biggest retailer of music in the United States. Over 50 million
people have used iTunes since its inception but the market for downloadable music is becoming
more contestable as the major players line up for a share of the supernormal profits that are
available. MySpace has entered into a joint venture with Universal, Sony BMG and Warner and will
now compete with rivals such as Last FM (a free streaming service) eMusic and Napster.
According to the new data (which covers the month of January) 48 percent of US teenagers didn‘t
buy a single CD in 2007, compared to 38 percent in 2006. Paid music downloads in the USA
accounted for almost 30 percent of all music sold in January.
Music sales in the USA (for Jan 2008):
iTunes Store - 19 percent
Wal-Mart - 15 percent
Best Buy - 13 percent
Amazon - 6 percent
Source: Tutor2u blog, April 2008
Suggestions for further reading on contestable markets
Bus deregulation is not working (BBC news, October 2006)
HD DVD defeat hits Toshiba profit (BBC news, March 2008)
Laser treatment deregulation fear (BBC news, February 2008)
London tailors face low-cost rival (BBC news, March 2008)
Question marks over the future of Digital Radio (Tutor2u blog, February 2008)
Renault-Nissan joins the race to produce a $2500 car (Tutor2u blog, May 2008)
Sony in danger of losing game crown to Nintendo (The Times, July 2008)
Tesco adds to contestability in digital downloads (Tutor2u blog, April 2008)
Console makers in three way shoot-out (Independent, October 2008)
Google and market contestability
Emperor for life Google and the search engine market (Financial Times, May 2008)
Newbies on Google‘s horizon (Tutor2u blog, June 2008)
Search site aims to rival Google (BBC news, July 2008)
Contestability in the airline industry
A new era for air travel (Tutor2u blog, March 2008)

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Open Skies deal comes into effect (BBC news, March 2008)
Transatlantic price war (BBC news, February 2008)
19. Monopsony Power in Product Markets
Monopsony is an important idea in economics but not often discussed in the media – indeed there
were only six references to it in the Financial Times between 2003 and 2008! But for economists
wanting to understand changes in the balance of power between buyers and sellers in different
markets and how this affects prices, profit margins and incentives, it is important to have an
understanding of monopsony and its effects. At A2 level you will not be expected to use diagrams
to show the impact of monopsony power in product markets.
What is monopsony power?
A monopsonist has buying power in their market. This buying power means that a monopsonist
can exploit their bargaining power with a supplier to negotiate lower prices. The reduced costs of
purchasing inputs increases their potential profit margins. Monopsony exists in both product and
labour markets – in this chapter we focus on buying power in the markets for goods and services.
Examples of industries where monopsony power exists and persists:
1. The ability of the electricity generators to negotiate lower prices when negotiating coal and
gas supply contracts‘
2. The major food retailers have power when purchasing supplies from meat and poultry
farmers, milk producers, wine growers and other suppliers. Given that the four major
supermarkets now dominate the industry (namely Tesco, Sainsbury, Wal-Mart-Asda and
Cooperative-Somerfield) I t might be more accurate to describe them as having
oligopsony power when it comes to purchasing products from businesses at earlier
stages of the supply-chain.
3. A car-rental firm seeking a contract to a car manufacturer to supply thousands of new cars
for their fleet
4. Low-cost airlines reaping the benefits of monopsony power when purchasing a new fleet of
aircraft
5. British Sugar buys almost the entire sugar beet crop produced in the UK year
6. Amazon‘s buying power in the retail book market – it gets a better price than other
booksellers and this gives it a significant competitive advantage.
7. The increasing buying power of countries – for example China – in securing deals to buy
mineral deposits from other countries – often in less developed nations in Africa.
8. The government is a major buyer e.g. in military procurement – and might be able to use
this bargaining power when confirming contracts for new military equipment and supplies.
Case Studies on Monopsony Power
Dividing the spoils in the milk industry
―Supermarkets use their gigantic size and bargaining power to capture almost all of the profit from
the milk industry, leaving farmers with a tiny proportion of the total: equal to only half a pence for
each litre of milk.‖ That is the central finding of new research by Drs Howard Smith and John

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Thanassoulis presented at the Royal Economic Society‘s 2008 annual conference. Farmers are in
the weakest position, only able to secure 0.5 pence per litre, or about 3% of the total supply chain
profits from liquid milk.‖
The research suggests that dairy farmers might help to counter-balance the power of the
supermarkets by strengthening farmers‘ cooperatives. This is already happening in many parts of
the country. But fundamentally the retailers will always hold the whip hand in pricing negotiations
and contract agreements. The danger is that the market failure due to excessive monopsony
power will lead to many more milk farmers leaving the industry, thereby increasing the demand for
imported milk.
Is the buying power of dairies such as Robert Wiseman and Dairy Crest, who then sell much of
their processed milk to large supermarkets such as Tesco and Asda, resulting in a fair deal for the
small scale dairy farmer – the price taker? When a market has a sole buyer, a monopsony, prices
are depressed by the buying power of the only outlet for the producers. Arguably the dairy farmer
has lost out to the combined buying power of the dairies and the supermarkets.
Source: Tutor2u Economics Blog, March 2008 and Robert Nutter, EconoMax, November 2006
Halfords and their relationships with suppliers
In late 2005 allegations of abuse of buying power were directed at the UK bike and car accessory
retailer Halfords. Halfords, with over 400 retail outlets, are twelve times larger than their nearest
rival and thus suppliers rely strongly on their custom. In December 2005 it was reported in the
financial press that Halfords were changing the terms of their agreements with suppliers. In
particular Halfords allegedly told their suppliers that that would be paid in 120 days not 90 days as
had been the practice since 2003, before which it was 30 days. Halfords would benefit by an extra
£53.2 million - almost twice the capital spending by the firm for the period. In addition Halfords
allegedly demanded a 5% across the range cut in prices and a bigger contribution to the
company‘s advertising spend by suppliers. The key issue is whether Halfords‘ actions restrict,
distort or prevent competition. Has the balance of power in the market shifted too much in favour of
the buyer causing an unfair fall in prices and profits for sellers?
Source: Robert Nutter, EconoMax, February 2006
Monopsony power is often given a bad press! We read of ‗greedy supermarkets‘ abusing their
buying power to force down profit margins for suppliers and enjoy higher returns for themselves. In
evaluation it is important to remember some of the possible advantages from monopsony power:
1. Improved value for money – for example the UK national health service can use its
bargaining power to drive down the prices of routine drugs used in NHS treatments and
ultimately this means that cost savings allow for more treatments within the NHS budget
2. Producer surplus has a value as well as consumer surplus – lower input costs will raise
profitability which might be used to fund capital investment and research
3. A monopsonist can act as a useful counter-weight to the selling power of a monopolist
4. In most supply chain relationships – for example between supermarkets and their suppliers
– the long term sustainability of an industry requires that both benefit – if there are no
mutually beneficial gains from trade, ultimately trade and exchange will break down.
5. The growth of the Fair Trade label and organisation is evidence of how pressure from
consumers can lead to improved contracts and prices for farmers in developing countries.
Suggestions for further reading on the economics of monopsony power
Barack Obama and John McCain go to war with Big Pharma (The Times, July 2008)
Bookstores – clubbing together to beat the big boys (BBC news, July 2008)

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Milk prices report sparks call for fair trade rules in UK (Wales online, March 2008)
Supermarket powers to be curbed (BBC news, February 2008)
Tate and Lyle sugar to be FairTrade (BBC news, February 2008)
Tesco to pay dairy farmers more (BBC news, April 2007)
20. Consumer and Producer Surplus
Consumer and producer surplus explained
Consumer surplus is the difference between the total amount that consumers are willing
and able to pay for a good or service (indicated by the demand curve) and the total amount
that they actually pay (the market price).
Producer surplus is the difference between what producers are willing and able to supply
a good for and the price they actually receive. The level of producer surplus is shown by the
area above the supply curve and below the market price.
Economic efficiency
Economic efficiency is achieved when an output of goods and services is produced making the
most efficient use of our scarce resources and when that output best meets the needs and wants
and consumers and is priced at a price that fairly reflects the value of resources used up in
production.
1. If in an economy, no one can be made better off without making someone else worse off,
the conditions for allocative efficiency have been met.
2. If in an economy, production of goods and services takes place at minimum of feasible
average cost, the conditions for productive efficiency have been met.
Price
Quantity
Demand
Supply
P1
Q1
Equilibrium Point
Consumer
Surplus
Producer Surplus

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Radiohead - Paying the price you are willing to pay
Radiohead's new album In Rainbows was released to a wave of publicity largely surrounding their
innovative pricing strategy. Fans were invited to name their own price for the downloadable mp3
files and in the event, nearly two-thirds of down loaders paid nothing. Indeed internet monitoring
company Comscore found that only 38% of down loaders willingly paid to do so and the average
price paid for the album was £2.90. One person in ten was willing to pay between £3.80 and £5.71
for the album.
Source: Adapted from news reports
Price discrimination and consumer & producer surplus
Price discrimination occurs when a firm charges a different price to different groups of consumers
for an identical good or service, for reasons not associated with the costs of supply. Is price
discrimination something that economists should be supporting in terms of the behaviour of
businesses and final outcomes in different markets?
Pure (1st
degree) discrimination
With 1st
degree price discrimination the firm is able to perfectly segment the market so that the
consumer surplus is removed and turned into producer surplus. Thus there is a clear transfer of
welfare from consumers to producers. This is shown in the next diagram.
Costs
Revenues
Output (Q)
Market Demand
Supply in a competitive market
P1
Q1
Consumer
Surplus (CS)
Producer
Surplus (PS)
P2
Q2
Net Loss of Economic
Welfare from price P2 raised
above the equilibrium price
Allocative efficiency in a competitive market
At the competitive market equilibrium price and output, we maximise consumer and producer
surplus. No one can be made better off without making someone else worse off – this is known as
the condition required for a Pareto optimal allocation of resources
Allocative efficient price
and output at the market
equilibrium
Requires other markets to
be competitive as well!

105
Third degree (or multi-market) price discrimination involves charging different prices for the same
product in different segments of the market. The key is that third degree discrimination is linked
directly to consumers‘ willingness and ability to pay for a good or service. It means that the prices
charged may bear little or no relation to the cost of production. Clearly the elasticity of demand is
the key factor determining the pricing decision for producers for each segment of the market.
The market is usually separated in two ways: by time or by geography. For example, exporters
may charge a higher price in overseas markets if demand is found to be more inelastic than it is in
Market A
Market B
MC=AC
QuantityQuantity
Price Price
Pa
Pb
MRa
MRb ARb
ARa
Profit from selling to market A
– with a relatively elastic
demand – and charging a
lower price
Demand in segment B of the
market is relatively inelastic. A
higher unit price is charged
MC=AC
QbQa
Consumer surplus at Price Pa Consumer surplus at Price Pa
Quantity of Output (Q)
Price (P)
AR (Market Demand)
MR
P1
Average Cost = Marginal Cost
Q1
P2
P4
Q3Q2
Equilibrium output with perfect price
discrimination – the monopolist will sell an
extra unit providing that the next unit adds
as much to revenue as it does to cost
P3
P5
Q4 Q5
Consumer surplus is turned into
extra revenue for the producer
= additional producer surplus
(higher profits)

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home markets. There is more consumer surplus to be exploited when demand is insensitive to
price changes.
21. Price Takers and Price Makers – Pricing Power
In this summary chapter we draw together strands from previous chapters and consider the key
factors that influence the ability of businesses to determine prices as they compete in markets.
The factors that determine the variety of pricing decisions open to a business nearly always come
back to two main driving forces
o The market structure in which a business operates.
o The objectives that a business may be pursuing at a given time.
―Fixing the price‖ does not necessarily imply some anti-competitive type of behaviour! It refers to
the power that a firm has to use some discretion in the prices it charges to groups of consumers
for one or more products
Most businesses are multi-product firms servicing a variety of different markets. Indeed markets
can become highly segmented – each with their own characteristics – so the factors will vary from
industry to industry.
Key factors affecting the pricing power of a business
(1) Market Structure
Perfect competition
o Price–taking firms have no influence over the ruling market price.
o Free entry and exist of businesses in the long run – drives down profits towards normal.
o Each supplier produces homogeneous products hence the perfectly elastic demand curve.
Pure monopoly
Market Demand and Supply Individual Firm‟s Costs and Revenues
Price (P) Price (P)
Market
Demand
Market
Supply
P1
Q1
AR (Demand) = MR
MC (Supply)
AC
P1
AC1
Q2

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o The monopolist has the ability to earn supernormal profits in the short and the long run.
o Their market position may be protected through the use of entry barriers.
o There is the potential for frequent use of price discrimination.
Oligopoly
o Oligopoly is competition among the few (with high likelihood of a few dominant firms).
o Each firm has some market power, supplies branded products and entry barriers exist.
o Key factor is the interdependent nature of pricing decisions between rival firms.
o Each firm must consider strategic behaviour of other “players” in the market.
o Objective might be protecting market share rather than pure profit maximisation.
Contestable markets
o Contestable markets are markets where the entry and exit costs are low.
o Potential for hit and run entry to cream off profits if incumbent firms are being inefficient.
o The threat of new entry from new suppliers or new products affects the current behaviour of
existing firms (may force them to price more competitively – less scope for monopoly
pricing).
o There are barriers to contestability– the higher the barriers, the greater the pricing power in
the hands of the incumbent firms because the risk of ―hit and run entry‖ is lower.
(2) Price and Cross-price Elasticity of Demand
Elasticity of demand remains a fundamental factor affecting a firm‘s pricing power:
o When demand is inelastic, a business can raise price without losing a disproportionate level
of sales.
o When demand is price elastic, the potential to raise price and extract consumer surplus,
turning it into higher producer surplus / profit is reduced.
Costs
Output (Q)
SRAC
AR
(Monopoly)
MR
MC
Q1
P1
AC1
Profit at Price P1
= (price – AC) x output Q1
Profit margin = P1 - AC1

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Cross price elasticity of demand is linked to this – i.e. the percentage change in demand for good X
resulting from a given percentage change in the price of a related product (in particular the relative
price of a substitute)
When the cross-elasticity of demand is low, the ―substitution-effect‖ from changes in relative
prices is weak consumers are less likely to switch their demand, giving the firm greater price
power.
(3) Product differentiation – moving away from homogeneous products
o Some consumers willing to pay premium prices for new products (known as ―early-
adopters‖).
o Products towards the end of their life-cycle – more elastic demand, lower prices.
o Impact of marketing and advertising on consumer loyalty / brand loyalty.
(4) The Regulatory System
Government appointed regulatory agencies may intervene directly or indirectly in the price-setting
process. The regulatory agencies cover privatised utilities such as gas, electricity,
telecommunications, the airports and the rail industry – most of these regulators have at times
enforced ‗price-capping formulae‘ limiting the extent to which the utilities can increase prices year
on year. Some of the regulators have now lifted price controls because they believe that there is
now sufficient competition in the market (a good example is the gas industry.)
(5) The International Environment
Most businesses face competition either from domestic rivals or from international competitors.
Increasingly the pricing decisions of one business are influenced by the strength of competition
from overseas suppliers. Globalisation has made this a key factor in many industries
(6) The Economic Cycle
The pricing power of a business (or a group of firms within a market) is also affected by
macroeconomic variables including the strength of domestic and global demand at different stages
of the economic cycle. When demand is strong and rising (e.g. during the upturn phase of the
economic cycle), a business will have more ―pricing power‖ than when demand is much weaker
Costs
Output (Q)
SRAC
AR
(Monopoly)MR
MC
Q1
P1
AC1
Low Price Elasticity of Demand
SRAC
MR
MC
P1
AC1
Q2
High Price Elasticity of Demand
AR
(Monopoly)

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and falling (e.g. during a recession). Often a market may be affected by a demand-side ―shock‖
which takes away the pricing power of suppliers. The airline industry in the wake of the terrorist
attacks in 2001 could be considered as an example of this.
Summary of the main factors affecting a firm‟s pricing power
Category Influence on Pricing Policy
Costs In order to make a profit, a business should ensure that its products are priced
above their average cost. In the short-term, it may be acceptable to price below
AC if this price exceeds marginal cost – so that the sale still produces a positive
contribution to fixed costs.
Competitors If the business is a monopolist, then it has price-setting power. At the other
extreme, if a firm operates under conditions of perfect competition, it has no
choice and must accept the market price.
The reality is usually somewhere in between. In such cases the chosen price
needs to be considered relative to those of close competitors and with one eye to
the likely reaction of rival firms when a business changes its pricing strategy.
Customers Consideration of customer expectations about price must be addressed. Ideally,
a business should attempt to quantify its demand curve to estimate what volume
of sales will be achieved at given prices and also the price elasticity of demand
when prices change
Business
Objectives
Possible pricing objectives include:
To maximise profits or to achieve a target return on a capital investment project
To achieve a target sales figure in a given time period
To achieve a target market share
To match the competition, rather than lead the market
Summary on Market Structures
Market structure is best defined as the organisational and other characteristics of a market. We
focus on those characteristics which affect the nature of competition and pricing – but it is
important not to place too much emphasis simply on the market share of the existing firms in an
industry.
Traditionally, the most important features of market structure are:
 The number of firms (including the scale and extent of foreign competition)
 The market share of the largest firms (measured by the concentration ratio – see below)
 The nature of costs (including the potential for firms to exploit economies of scale and
also the presence of sunk costs which affects market contestability in the long term)
 The degree to which the industry is vertically integrated - vertical integration explains
the process by which different stages in production and distribution of a product are under
the ownership and control of a single enterprise. A good example of vertical integration is
the oil industry, where the major oil companies own the rights to extract from oilfields, they
run a fleet of tankers, operate refineries and have control of sales at their own filling
stations.

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 The extent of product differentiation (which affects cross-price elasticity of demand)
 The structure of buyers in the industry (including the possibility of monopsony power)
 The turnover of customers (sometimes known as ―market churn‖) – i.e. how many
customers are prepared to switch their supplier over a given time period when market
conditions change. The rate of customer churn is affected by the degree of consumer or
brand loyalty and the influence of persuasive advertising and marketing
Characteristic Perfect Competition Oligopoly Monopoly
Number of firms Many Few One
Type of product Homogenous Differentiated Limited
Barriers to entry None High High
Supernormal short run
profit
  
Supernormal long run
profit
  
Pricing Price taker Price maker Price maker
Non price competition   
Economic efficiency High Low Low
Innovative behaviour Weak Very Strong Potentially strong
Market structure and innovation
Which market conditions are optimal for effective and sustained innovation to occur? This is a
question that has vexed economists and business academics for many years.
High levels of research and development spending are frequently observed in oligopolistic
markets, although this does not always translate itself into a fast pace of innovation.
The recent work of William Baumol (2002) provides support for oligopoly as market structure best
suited for innovative behaviour. Innovation is perceived as being ―mandatory‖ for businesses that
need to establish a cost-advantage or a significant lead in product quality over their rivals.
―As soon as quality competition and sales effort are admitted into the sacred precincts of theory,
the price variable is ousted from its dominant position…..But in capitalist reality as distinguished
from its textbook picture, it is not that kind of competition which counts but the competition which
commands a decisive cost or quality advantage and which strikes not at the margins of profits and
the outputs of the existing firms but at their foundations and their very lives. This kind of
competition is as much more effective than the other as a bombardment is in comparison with
forcing a door‖
Supernormal profits persist in the long-run in an oligopoly and these can be used to finance
research and development.

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22. Competition Policy and Regulation
Competition policy covers the different ways in which the competition authorities of national
governments and the European Union seek to make markets work better and achieve a higher
level of economic efficiency and economic welfare.
Main Aims of Competition Policy
The aim of competition policy is promote competition; make markets work better and contribute
towards increased efficiency and competitiveness of the UK within the European Union single
market. Competition policy aims to ensure
o Wider consumer choice.
o Technological innovation which promotes dynamic efficiency.
o Effective price competition between suppliers.
o Investigating allegations of anti-competitive behaviour which affect consumer welfare.
There are four key pillars of competition policy in the UK and in the European Union
1. Antitrust & cartels: This involves the elimination of agreements which seek to restrict
competition including price-fixing and other abuses by firms who hold a dominant market
position.
2. Market liberalisation: Liberalisation involves introducing fresh competition in previously
monopolistic sectors such as energy supply, telecommunications and air transport.
3. State aid control: Competition policy analyses examples of state aid measures by EU
Member State governments to ensure that such measures do not distort competition in the
Single Market (e.g. the prohibition of a financial grant designed to keep a loss-making firm
in business even though it has no prospect of long-term recovery).
4. Merger control: This involves the investigation of mergers and take-overs between firms
(e.g. a merger between two large groups which would result in their dominating the market).
The Regulators
Regulators are appointed by the government to oversee how a market works and the outcomes
that result for both producers and consumers. Examples of regulators include:
What do the regulators regulate?
1. Prices: Regulators aim to ensure that companies do not exploit monopoly power by
charging excessive prices and pass on part of any reduction in costs to consumers in lower
prices
2. Standards of customer service: Companies that fail to meet specified service standards
can be fined or have their franchise / licence taken away. The regulator may also require
that unprofitable services are maintained in the wider public interest e.g. BT keeping phone
booths open in rural areas and inner cities; the Royal Mail is still required by law to provide
a uniform delivery service at least once a day to all postal addresses in the UK
3. Opening up markets: The aim here is to encourage competition by removing barriers to
entry. This might be achieved by forcing the dominant firm in the industry to allow others to
use its infrastructure network. A key task for the regulator is to fix a fair access price for
firms wanting to use the existing infrastructure.

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4. Regulation acts as a form of surrogate competition – attempting to ensure that prices,
profits and service quality are similar to what could be achieved in competitive markets.
Anti-Trust Policy - Abuses of a Dominant Market Position
A firm holds a dominant position if its power enables it to operate within the market without taking
account of the reaction of its competitors or of intermediate or final consumers.
Competition authorities consider a firm‘s market share, whether there are credible competitors,
whether the business has ownership and control of its own distribution network (achieved
through vertical integration) and whether it has favourable access to raw materials.
Holding a dominant position is not wrong in itself if it is the result of the firm's own competitiveness
against other businesses! But if the firm exploits this power to stifle competition, this is deemed to
be an anti-competitive practice.
A recent example of this has been the long investigation and legal battle by the EU Commission
into the alleged abuse of market power by Microsoft.
Anti-Competitive Practices:
Anti-competitive practices are strategies designed deliberately to limit the degree of competition
inside a market. Such actions can be taken by one firm in isolation or a number of firms engaged in
explicit or implicit collusion. Since 1998 there have been numerous investigations in industries
such as chemicals, banks, pharmaceuticals, airlines, beer, and paper, plasterboard, food
preservatives and computer games! These were covered in the chapter on oligopoly.
Examples of anti-competitive practices
1. Predatory pricing (also known as ‗destroyer pricing‘) financed through cross-
subsidization – this happens when one or more firms deliberately sets prices below
average cost to incur losses for a sufficiently long period of time to eliminate, discipline, or
deter entry by a competitor – and then tries to recoup the losses by raising prices above the
level that would ordinarily exist in a competitive market.
2. Vertical restraint in the market:
a. Exclusive dealing: This occurs when a retailer undertakes to sell only one
manufacturers product. These may be supported with long-term contracts that bind
or “lock-in” a retailer to a supplier and can only be terminated by the retailer at high
financial cost. Distribution agreements may seek to prevent instances of parallel
trade between EU countries (e.g. from lower-priced to higher priced countries).
b. Territorial exclusivity: This exists when a particular retailer is given the sole rights
to sell the products of a manufacturer in a specified area.
c. Quantity discounts: Where retailers receive larger price discounts the more of a
given manufacturer's product they sell - this gives them an incentive to push one
manufacturer's products at the expense of another's.
d. A refusal to supply: Where a retailer is forced to stock the complete range of a
manufacturer's products or else he receives none at all, or where supply may be
delayed to the disadvantage of a retailer.
3. Collusive practices: These might include agreements on market sharing, price-fixing and
agreements on the types of goods to be produced.
Price Fixing – The Office of Fair Trading
UK competition law now prohibits almost any attempt to fix prices - for example, you cannot

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o Agree prices with your competitors, e.g. you can't agree to work from a shared
minimum price list.
o Agree to share markets or limit production to raise prices.
o Impose minimum prices on different distributors such as shops.
o Agree with your competitors what purchase price you will offer your suppliers.
o Cut prices below cost in order to force a weaker competitor out of the market.
o The law doesn't just cover formal agreements. It also includes other activities with a
price-fixing effect. For example, businesses should not discuss your pricing plans
with competitors.
Cartels and the law in the UK
Cartels are a particularly damaging form of anti-competitive behaviour - taking action against them
is one of the OFT's priorities. Under the Competition Act 1998 and Article 81 of the EU Treaty,
cartels are prohibited. Any business found to be a member of a cartel could be fined up to 10 per
cent of its worldwide turnover. In addition, the Enterprise Act 2002 makes it a criminal offence for
individuals to dishonestly take part in the most serious types of cartels. Anyone convicted of the
offence could receive a maximum of five years imprisonment and/or an unlimited fine.
Source: OFT web site
There have been many examples of allegations of and investigations in price fixing and other forms
of collusive behaviour in UK and European markets in recent years. They all provide interesting
evidence of how the competition authorities both in the UK and in the European Union are using
their enhanced powers under new competition laws to investigate possible instances of price fixing
or anti-competitive behaviour.
Some collusive behaviour is tolerated / encouraged
Not all instances of collusive behaviour are deemed to be illegal by the European Union
Competition Authorities. Practices are not prohibited if the respective agreements "contribute to
improving the production or distribution of goods or to promoting technical progress in a market.”
o Development of improved industry standards /technical standards of production and
safety which eventually benefit the consumer.
o Research joint-ventures and know-how agreements which seek to promote innovative
and inventive behaviour in a market.
Market Liberalization
The main principle of EU Competition Policy is that consumer welfare is best served by introducing
competition in markets where monopoly power exists. Frequently, these monopolies have been in
network industries for example transport, energy and telecommunications. In these sectors, a
distinction must be made between the infrastructure and the services provided directly to
consumers using this infrastructure.
While it is often difficult to establish a second, competing infrastructure, for reasons linked to
investment costs and efficiency (i.e. the natural monopoly arguments linked to economies of
scale and a high minimum efficient scale) it is possible and desirable to create competitive
conditions in respect of the services provided.
The European Commission has developed the concept of separating infrastructure from
commercial activities. The infrastructure is thus the vehicle of competition. While the right to
exclusive ownership may persist as regards the infrastructure (the telephone or electricity network
for example or the supply of gas and electricity to the individual household and business),

114
monopolists must grant access to companies wishing to compete with them as regards the
services offered on their networks.
State Aid in Markets
The argument for monitoring state aid given to private and state businesses by member
Government is that by giving certain firms or products favoured treatment to the detriment of
other firms or products, state aid disrupts normal competitive forces. According to the EU
Competition Commission, neither the beneficiaries of state aid nor their competitors prosper in the
long term. Often, all government subsidies achieve is to delay inevitable restructuring operations
without helping the recipient actually to return to cost and non-price competitiveness. Unsubsidised
firms who must compete with those receiving public support may ultimately run into difficulties,
causing loss of competitiveness and endangering the jobs of their employees.
Under the current European state aid rules, a company can be rescued once. However, any
restructuring aid offered by a national government must be approved as being part of a feasible
and coherent plan to restore the firm‘s long-term viability. Government aid designed to boost
research and development, regional economic development and the promotion of small
businesses is normally permitted.
Here are some recent examples of the state aid /state subsidy issue in the news. They nearly
always relate to industries and businesses either suffering short term losses whose future is under
threat or those struggling to cope and adjust to long-term economic decline.
Report rules out state aid for the UK fishing industry (BBC news, July 2008)
EU sets Poland shipyard deadline (BBC news, July 2008)
Alitalia calls for urgent support (BBC news, May 2008)
Merger Policy in the UK and the European Union
Corporate restructuring is a fact of life. There is a natural tendency for markets to consolidate over
take through a process of horizontal and vertical integration. The main issue for competition
policy is whether a proposed merger or takeover between two businesses is thought to lead to a
substantial lessening of competitive pressures in the market and risks leading to a level of
market concentration when collusive behaviour might become a reality.
When companies combine via a merger, an acquisition or the creation of a joint venture, this
generally has a positive impact on markets: firms usually become more efficient, competition
intensifies and the final consumer will benefit from higher-quality goods at fairer prices.
However, mergers which create or strengthen a dominant market position can, after investigation,
be prohibited in order to prevent ensuing abuses. Acquiring a dominant position by buying out
competitors is in contravention of EU competition law.
Companies are usually able to address the competition problems, normally by offering to divest
(sell or off-load) part of their businesses. In December 2007, the UK Competition Commission
announced that the broadcaster BSkyB would be forced to sell some of its 17.9% stake in ITV.
Suggestions for further reading on competition policy
Calls for moves over media mergers (BBC news, June 2008)
US merger forms largest airline (BBC news, April 2008)

115
BSkyB told to sell shares in ITV (BBC news, January 2008)

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23. Privatisation and Deregulation
Privatisation became one of the most significant microeconomic policies of the 1980s and 1990s.
We look briefly at some of the issues involved in transferring assets from the public to the private
sector of the economy.
What is privatisation?
Privatisation means the transfer of assets from the public (government) sector to the private
sector. In the UK the process has led to a sizeable reduction in the size of the public sector of the
economy. State-owned enterprises now contribute less than 2 per cent of GDP and less than 1.5%
of total employment. Privatisation has become a common feature of microeconomic reforms
throughout the world not least in the transition economies of Eastern Europe as they have made
progress towards becoming fully-fledged market economies.
Nationalisation
Nationalisation occurs when assets are taken back into state ownership – the most recent
examples in the UK are the re-nationalisation of Northern Rock (2007) and Network Rail (formerly
Railtrack) in 2002.
Major privatisations
The major privatisations in the UK over the last twenty five years have occurred with the following
businesses (the year of privatisation is in parenthesis).
o Associated British Ports (1983)
o British Aerospace (1980) – eventually
merged with Marconi Electronic
Systems
o British Airports Authority (1986) –
subsequently bought by Grupo
Ferrovial in 2006
o British Airways (1987)
o British Coal (1994) – in 1994, UK
Coal‘s assets were merged with RJB
Mining to form UK Coal plc
o British Gas (1986) - In 1997 British
Gas plc de-merged Centrica plc and
renamed itself BG plc (later BG Group
plc). in Britain it is used by Centrica,
while in the rest of the world it is used
by BG Group
o British Petroleum - In August 1998,
British Petroleum merged with the
Amoco Corporation (Amoco), forming
"BP Amoco."
o British Rail (privatised in stages
between 1994 and 1997) – created
Railtrack – which was renationalised
in 2002
o British Steel (1988) – British Steel
merged with the Dutch steel producer
Koninklijke Hoogovens to form Corus
Group on 6 October 1999. Corus was
bought by Indian steel firm Tata in
2007.
o British Telecom (1984)
o National Power and PowerGen (1990)
- 1990 the Central Electricity
Generating Board was split into three
generating companies (Powergen,
National Power and Nuclear Electric
plc.) and electricity transmission
company, National Grid Company.
o Regional water companies
The early examples of privatisation such as the sale of British Telecom to the private sector in
1984 represented a simple transfer of ownership as shares were offered for sale via the stock
market. More recently the privatisation process has become more complex. The focus has
switched to breaking up existing statutory monopoly power through a process of deregulation
and liberalisation of markets – basically designed to introduce competition where once monopoly
power was well established.

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Market forces have been introduced in social services, the NHS and in higher education.
What remains of the public sector?
Daily closing price, £s per share
Northern Rock Ordinary Share Price
97 98 99 00 01 02 03 04 05 06 07 08
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Privatisation has radically changed the public or government sector of the economy although since
the current Labour government came to power, there has been a huge rise in total public sector
employment, in part the result of a large rise in government spending on the national health
services. The following businesses remain part of the public sector:
o British Nuclear Fuels plc - an international company, owned by the British
government, concerned with nuclear power.
o Network Rail - Network Rail is a "not for dividend" company that owns the fixed
assets of the UK railway system that formerly belonged to British Rail, the now-
defunct British state-owned railway operator. Network Rail owns the infrastructure
itself, railway tracks, signals, tunnels, bridges, level crossings and most stations, but
not the rolling stock. Network Rail took over ownership by buying Railtrack plc,
which was in "Railway Administration", for £500 million from Railtrack Group plc.
o The Royal Mail - Royal Mail has been a state-owned company since 1969 and
remains a public limited company wholly owned by the UK government. The Royal
Maul is regulated by PostComm which has the power to grant licences to new
competitors entering the deregulated market for household and business mail
services. The market was opened up to full competition in January 2006. The Royal
Mail retains a universal service commitment.
o Northern Rock - In the autumn of 2007 the government announced the
nationalisation of Northern Rock - all shares in the business were handed over to
the Treasury. The government claimed at the time that this would be a temporary
period of state ownership and that the business would eventually be returned to the

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private sector. The main justification for the decision was that Northern Rock's
business model had failed but that the economic and social consequences of
allowing the business to go bust were too severe - hence the need for government
intervention. Weeks earlier Northern Rock ran into a financial crisis which led to the
first run on a major UK bank since the nineteenth century. It was forced to ask the
Bank of England for emergency funding. With nationalisation, the debts of the bank
were taken onto the public sector finances. These loans and guarantees were
estimated to be worth more than £50bn. In the months since the nationalisation,
Northern Rock has been downsizing its activities, reducing the size of its mortgage
loans book and making several thousand employees redundant.
The main economic arguments for privatisation and deregulation
Supporters of privatisation believe that the private sector and the discipline of free market forces
are a better incentive for businesses to be run efficiently and thereby achieve improvements in
economic welfare. The argument is that extra competition in markets will lead to reductions in
price levels for consumers and improvements over time in dynamic efficiency.
Privatisation was also seen as a way of reducing trade union power and encouraging an increase
in capital investment as businesses were now free to raise extra financial capital through the stock
market.
The main arguments against privatisation
Opponents of privatisation argued that state owned enterprises had already faced competition
when part of the public sector and that in several instances the transfer of ownership merely
replaced a public sector monopoly with a private sector monopoly.
There were criticisms that state assets were sold off by the government at too low a price and that
the consequences of privatisation has been a decrease in investment and large scale reductions in
employment as privatised businesses have sought to cut their operating costs.
Deregulation of markets
Another important policy in industries where welfare and efficiency might be affected by the
dominant market power of some suppliers is to open up markets and encourage the entry of new
suppliers – a process called de-regulation of product markets. Examples of this in the UK
include the opening up of markets for household energy supplies, the liberalisation of household
mail services and financial deregulation affecting both banks and building societies.
The expansion of the European Single Market has accelerated the process of market liberalisation.
The Single Market seeks to promote four freedoms – namely the free movement of goods,
services, financial capital and labour. In the long term we can expect to see the microeconomic
effects of the EU Single Market working their way through many British markets and the general
expectation is that competitive pressures for all businesses working inside the European Union will
continue to intensify.
Product market liberalisation involves breaking down barriers to entry in industries and making
them more contestable. The aim is to boost market supply, bring down prices for consumers, and
encourage an increase in competition, investment and productivity leading to a rise in economic
efficiency. In the long term, if product markets become more competitive and investment flows into
these industries, there are macroeconomic implications for example an increase in an economy‘s
underlying trend rate of economic growth which might contribute to an improvement in average
standards of living.
Utility regulators
Utility regulators oversee the activities of companies privatised over the last two decades. These
former state-owned utilities are regulated to ensure that they do not exploit their monopoly position.
The main aims of the regulators have been to create and simulating the disciplines that companies
would experience inside a competitive market. In the long run, the thrust of regulation has been to

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encourage competition by easing the entry of new suppliers and making markets more
contestable.
o Ofwat – (water services regulation authority) – Ofwat is the body responsible for
economic regulation of the privatised water and sewerage industry in England and
Wales. Key issues for Ofwat at the moment include the threats of water shortages,
the problems of leaks and rising water bills.
o Ofcom - The Office of Communications is the UK's communications regulator
o Ofgem - The Office of Gas and Electricity Markets is the government regulator for
the electricity and downstream natural gas markets in Great Britain. Its primary duty
is to ―promote choice and value for all gas and electricity customers".
o Office of the Rail Regulator – ORR is the UK government's agency for regulation
of the country's railway network.
Price Capping for the Utilities
Price capping has been a dominant feature of regulation in recent years – although this is now
being phased out as most utility markets become more competitive. Inn reality, setting a price cap,
the industry regulator usually has in mind a ―satisfactory rate of return on capital employed‖ for
each business.
Basics of price capping
Price-cap regulation is a form of intervention in the price mechanism which has been applied at
various points in time to all of the privatised utility businesses in the UK. Price-capping is an
alternative to rate-of-return regulation, in which utility businesses are allowed to achieve a given
rate of return (or rate of profit) on capital. In the UK, price capping has been known as "RPI-X".
This takes the rate of inflation, measured by the Consumer Price Index and subtracts expected
efficiency savings X. In the water industry, the formula is "RPI - X + K", where K is based on capital
investment requirements designed to improve water quality and meet EU water quality standards.
This has meant increases in the real cost of water bills for millions of households in the UK.
Price capping has meant in most cases that average prices for consumers have fallen in real terms
although this has not been the case for all privatised industries. The assumption is that productivity
growth will help to accommodate the price caps. Profits for utilities can rise providing that efficiency
levels improve (i.e. firms are able to bring down their unit labour costs)
Arguments for and against price-capping for the utilities
Advantages
o Capping is an appropriate way to curtail the monopoly power of ―natural monopolies‖.
o Cuts in the real price levels are good for household and industrial consumers (leading to
an increase in consumer surplus and higher real living standards in the long run).
o Price capping helps to stimulate improvements in productive efficiency because lower
costs are needed to increase a producer‘s total profits.
o The price capping system is a useful tool for controlling consumer price inflation in the
UK.
Disadvantages
o Price caps have led to large numbers of job losses in the utility industries.
o Setting different price capping regimes for each industry distorts the working of the price
mechanism.

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Yell and price capping
Price capping is still used in the market for telephone directories where Yell has a dominant
position in the market. In June 2006 it was announced that Yell would still be subject to a price
capping formula because of the relative absence of competition in the industry. According to the
Competition Commission report, "Yell continues to hold a powerful position in this market and
competition is not working effectively. Prices are capped at the moment and without this price cap,
advertisers would pay more than in a well-functioning market. At present, Yell is subject to a yearly
price cap of RPI less 6% - so at the moment, the real cost of advertising rates are falling year-on-
year.
PostComm approves a rise in the price of stamps
Stamp prices rose in April 2006 under a compromise deal between regulator PostComm and the
Royal Mail. First class stamps would rose 2p to 32p and second class stamps by 1p to 22p, with
the possibility of them rising to 37p and 25p respectively by 2010. The Royal Mail had wanted to
push stamps up to 39p and 27p to help pay for capital investment and to plug a £4bn hole in its
pension fund.
Adapted from news reports
The UK rail industry was privatized between 1994 and 1997 and since that time, the average price
of a rail fare has risen faster than inflation – a trend shown in the diagram below. Fare changes are
announced by the Association of Train Operating Companies. Despite continuing high levels of
government subsidy, the train operating businesses have increased those fares that are
unregulated by more than inflation, partly because they have to high fees to Network Rail for
access to the track and infrastructure and because they have been making a contribution towards
improvements to rail safety.
Monthly fare index, Jan 1987 = 100
Index of Rail Fares in the UK
87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08
100
125
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Rail Fares
Overall Consumer Price Index

- 121 -
Changing Role of the Utility Regulators
Gradually the main utility regulators have withdrawn from price regulation because of the
increased degree of competition in the market. The main focus of the regulatory authorities is now
to provide improved price information for consumers to make prices of different suppliers more
transparent to improve the flow of information in the market.
The authorities also want to encourage free transfer for consumers between suppliers (by
monitoring and enforcing the nature of supply contracts) and keeping a close eye on anti-
competitive behaviour.
In telecommunications, one key decision made eventually by Ofcom was to enforce unbundling of
the local loop. Local loop unbundling is the process of allowing telecommunications operators to
use the telephone connections from the telephone exchange's central office or exchange to the
customer premises be it a household or a business location. In the UK this has meant opening up
the telephone exchanges owned by British Telecom and allowing broadband businesses such as
AOL-UK and Tiscali to put in their own equipment and then supply broadband services in direct
competition with BT to households. The vast majority of households are within one mile of their
local telephone exchange.
Although local look unbundling has taken time to become widespread, it has been one factor
behind the rapid expansion of market supply in broadband which is revolutionising the UK
telecommunications market.
One of the consequences of the greater level of competition in the telecommunications industry in
the UK is that in July 2006, Ofcom withdrew all price capping controls on British Telecom. After 22
years of having its prices controlled directly by an industry regulator, this marked an important
milestone in the privatisation and market liberalisation process.
The debate over water prices

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Index of prices, January 1987=100
Water and other charges
RPI: housing: water & other charges (Jan 1987=100)
RPI: All items retail prices index (January 1987=100)
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All Items Retail Price Index
Water Charges
When water was privatised in 1989, the average household bill was about £219. In 2006, it was
£303 - up 38%. Since the last price review in 2004, the average bill has gone up 10% and is
expected to rise about 20% plus inflation between 2005 and 2010.
The subsequent profits declared by the water industry have prompted an outcry that shareholders
are benefiting at the expense of customers. The problem has been exacerbated by PR disasters
such as Thames Water's handling of the drought last summer and an imposition of a hosepipe ban
while the company's pipes leaked millions of litres a day into the ground.
Water companies argue that the increases are needed for large-scale investment such as mending
burst pipes to meet leakage targets and improving waste disposal. The water industry invests more
capital in maintenance than all other utilities combined. Since privatisation, the sector has invested
over £50bn - half of that is down to meeting European Union directives. In 2004, it agreed with the
regulator to spend a further £16.8bn to 2010. Given that last year alone 3.6bn litres of water leaked
from UK pipes every day, it would appear that the money is needed.
Source: Adapted from newspaper reports, March 2007
Summary comments on privatisation
Privatisation has changed the face of the British economy over the last twenty five years. Over
twenty businesses have been transferred from the public sector to the private sector and many
remaining state sector enterprises are now subject to the disciplines of the market. The transfer of
ownership from one part of the economy to another has been, in many cases, rather a superficial
change. The more fundamental changes have occurred when monopoly powers have been broken
down either because of regulators legislating to open up the market, or because of the effects of
wider international changes such as the process of globalisation.
The performance of the privatised companies has been patchy. Most of them have seen their
monopoly powers eroded as their markets have become more contestable. Some privatisations

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have not worked, the most obvious example being the failure of rail privatization and the eventual
collapse of Railtrack when it went into administration.
There remain controversial issues about the size of the profits that some of the privatised utilities
are making, the water industry is a good example of this. In most utility markets there is now
genuinely more choice for consumers. And real price levels have come down over the longer term.
Suggestions for further reading on privatisation and nationalisation
Argentina renationalises airline (BBC news, July 2008)
Call for sell-off of the Royal Mail (BBC news, May 2008)
Guardian special reports on the Northern Rock
NHS dentists turning private (BBC news, July 2008)
NHS runs like a supermarket war (BBC news, July 2008)

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24. The Labour Market
The labour market is a factor market – it provides a means by which employers find the labour they
need, whilst millions of individuals offer their labour services in different jobs.
Background to Labour Demand
Marginal Revenue Product (MRPL) measures the change in total revenue for a firm from selling
the output produced by additional workers employed.
MRPL = Marginal Physical Product x Price of Output per unit
o Marginal physical product is the change in output resulting from adding an extra worker.
o The price of output is determined in the product market – in other words, the price that a
business can get in the market for the output that they have produced.
A simple numerical example of marginal revenue product is shown in the next table:
Labour
employed
Capital (K) Output (Q)
units
MPP
units
Price per
unit (£)
MRP = MPP x P (£)
0 5 0 / 5 /
1 5 30 30 5 150
2 5 70 40 5 200
3 5 120 50 5 250
4 5 180 60 5 300
5 5 270 90 5 450
6 5 330 60 5 300
7 5 370 40 5 200
8 5 400 30 5 150
9 5 420 20 5 100
10 5 430 10 5 50
We are assuming in this example that the firm is operating in a perfectly competitive market such
that the demand curve for finished output is perfectly elastic at £5 per unit. Marginal revenue
product follows directly the behaviour of marginal physical product. Initially as more workers are
added to a fixed amount of capital, the marginal product is assumed to rise. However beyond the
5th
worker employed, extra units of labour lead to diminishing returns. As marginal physical
product falls, so too does marginal revenue product. For example the 5th
worker taken on adds
$450 to total revenue whereas the 9th
worker employed generates just £100 of extra income.
The story is different if the firm is operating in an imperfectly competitive market where the demand
curve is downward sloping. In the next numerical example we see that as output increases, the
firm may have to accept a lower price per unit for the product it is selling. This has an impact on the
marginal revenue product of employing extra units of labour. One again though, a combination of
diminishing returns to extra labour and a falling price per unit causes marginal revenue product
(eventually) to decline. In our example below, it starts to fall once the 7th
worker is employed.

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Labour Capital (K) Output (Q) MPP Price (£) MRP = MPP x P (£)
0 5 0 10.0
1 5 25 25 9.60 240
2 5 60 35 9.00 315
3 5 100 40 8.70 348
4 5 150 50 8.20 410
5 5 210 60 7.90 474
6 5 280 70 7.70 539
7 5 360 80 7.00 560
8 5 430 70 6.80 476
9 5 450 20 6.50 130
10 5 460 10 6.00 60
MRP theory suggests that wage differentials result in part from variations in the level of labour
productivity and also the value of the output that the labour input produces.
The main assumptions of the marginal revenue productivity theory of the demand for labour are:
o Workers are homogeneous in terms of their ability and productivity (clearly unrealistic!)
o Firms have no buying power when demanding workers (they have no monopsony power.)
o Trade unions have no impact on the labour supply (the possible impact on unions on wage
determination is considered later.)
o The physical productivity of each worker can be accurately and objectively measured
and the market value of the output produced by the labour force can also be calculated.
o The industry supply of labour is assumed to be perfectly elastic. Workers are
occupationally and geographically mobile and can be hired at a constant wage rate. This
means that the marginal cost of taking on extra workers is assumed to be constant.
The profit maximising level of employment
Now we consider how many people a business might decide to employ. The profit maximising level
of employment occurs when a firm hires workers up to the point where the marginal cost of
employing an extra worker equals the marginal revenue product of labour. I.e. MCL = MRPL.
This is shown in the labour demand diagram shown below.

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o
Limitations of MRPL theory of labour demand
Although marginal revenue product theory is a useful aspect of labour market analysis it is
important to be aware of some of its limitations:
1. Measuring productivity: Often it is
hard to measure productivity because
no physical output is produced or the
output may not be sold at a market
price. This makes it tough to place a
true valuation on the output of each
extra worker. How does one go about
valuing the final output of people
employed in teaching or the health
service? It is easier to measure physical
output in industries where a tangible
product is produced each day.
2. Pay Award Bodies: In some jobs
wages and salaries are set
independently of the state of labour demand and supply. Over five million public sector
workers for example fire-fighters, council workers, nurses and teachers have their pay set
according to decisions of independent pay review bodies with ―market forces‖ having only
an indirect role in setting pay-rates.
3. Self employment and Directors‟ Pay: There are over three million people classified as
self-employed in Britain. How many of these people set their wages according to the
marginal revenue product of what they produce? And what of those people who have the
ability to set their own pay rates as directors or owners of companies?
Shifts in the Demand for Labour
The number of people employed at each wage level can change and in the diagram below we see
an outward shift of the labour demand curve. The curve shifts when there is a change in the
conditions of demand in the jobs market. For example:
A rise in the level of consumer demand for a product which means that a business needs
to take on more workers (see below on the concept of derived demand)
Wage
Rate
Employment of Labour (E)
Marginal Revenue Product (MRPL)
Marginal Cost of
Employing Labour
W1
E1E2
W2
E3
W3
A rise in the wage rate causes a contraction
of labour demand as the marginal cost of
employing extra workers rises
The profit-maximising
level of employment is
where the marginal
revenue product of labour
= the marginal cost of
employing labour

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An increase in the productivity of labour which makes using labour more cost efficient
than using capital equipment
A government employment subsidy which allows a business to employ more workers
The labour demand curve would shift inwards during an economic slowdown / recession when
sales of goods and services are in decline, business profits are falling and many employers cannot
afford to keep on their payrolls as many workers. The result is often labour redundancies and an
overall decline in the demand for labour at each wage rate.
Labour as a Derived Demand
The demand for all factor inputs, including labour, is a derived
demand i.e. the demand depends on the demand for the
products they produce. When the economy is expanding, we
expect to see a rise in the aggregate demand for labour
providing that the rise in output is greater than the increase in
labour productivity. In contrast, during a recession or a
slowdown, the aggregate demand for labour will decline as
businesses look to cut their operations costs and scale back on
production.
In a recession, business failures, plant shut-downs and short
term redundancies lead to a reduction in the derived demand
for labour. The construction industry is another example of the derived demand for labour. The
decade long property boom in the UK has led to rising prices, output and employment. But the
turnaround in the housing market is likely to lead to thousands of job losses during 2008 and 2009
as the market demand for workers in housing construction has shifted inwards.
Wage
Rate
Labour Demand (1)
W1
E1
Labour Demand (2)
E2

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Car-maker cuts jobs as sales fall
The biggest car-maker in the United States, General Motors, is shedding jobs from the assembly
plant to the boardroom as it struggles to respond to falling demand for its vehicles. Soaring petrol
prices and fears of recession have put motorists off buying its pick-up trucks and gas-guzzling
4x4s. Many Americans are switching to smaller, more fuel-efficient cars, which tend to be a
speciality of Asian motor manufacturers. General Motors has announced a two-year pay freeze
and a programme of voluntary redundancies as it looks to reduce labour costs. GM and its rivals -
Ford and Chrysler - have already cut more than 100,000 jobs since 2006.
Source: Adapted from news reports, June 2008
Elasticity of Demand for Labour
Elasticity of labour demand measures the responsiveness of demand for labour when there is a
change in the wage rate. The elasticity of demand for labour depends on these factors:
1. Labour costs as a % of total costs: When labour expenses are a high proportion of total
costs, then labour demand tends to be elastic. In many service jobs such as customer
service centres, labour costs are a high proportion of the total costs of a business.
2. The ease and cost of factor substitution: Labour demand will be more elastic when a
firm can substitute quickly and easily between labour and capital inputs. When specialised
labour or capital is needed, then the demand for labour will be more inelastic. For example
it might be fairly easy and cheap to replace security guards with cameras but a hotel would
find it almost impossible to replace hotel cleaning staff with machinery!
3. The price elasticity of demand for the final output produced by a business: If a firm is
operating in a highly competitive market where final demand for the product is price elastic,
they may have little market power to pass on higher wage costs to consumers.
Labour Supply
Wage
Rate
Labour Demand (1)
W1
W2
E2E1
Labour Demand (2)
E3
Labour demand (2) is more elastic – perhaps because the employer
can easily switch to capital inputs as a means of producing an output if
wage rates were to increase
Labour demand (1) is relatively inelastic – e.g. -0.4 i.e. a 10% fall in the
wage rate might only lead to a 4% expansion of labour demand

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The labour supply refers to the total number of hours that labour is willing and able to supply at
a given wage rate. It can also be defined as the number of workers willing and able to work in a
particular job or industry for a given wage.
The labour supply curve for any industry or occupation will be upward sloping. This is because, as
wages rise, other workers enter this industry attracted by the incentive of higher rewards. They
may have moved from other industries or they may not have previously held a job, such as
housewives or the unemployed. The extent to which a rise in the prevailing wage or salary in an
occupation leads to an expansion in the supply of labour depends on the elasticity of labour supply.
Key factors affecting labour supply
The supply of labour to a particular occupation is influenced by a range of factors:
1. The real wage rate on offer in the industry itself – higher wages raise the prospect of
increased factor rewards and should boost the number of people willing and able to work.
2. Overtime: Opportunities to boost earnings come through overtime payments, productivity-
related pay schemes, and share option schemes.
3. Substitute occupations: The real wage rate on offer in competing jobs is another factor
because this affects the wage and earnings differential that exists between two or more
occupations. So for example an increase in the relative earnings available to trained
plumbers and electricians may cause some people to switch their jobs.
4. Barriers to entry: Artificial limits to an industry‘s labour supply (e.g. through the
introduction of minimum entry requirements or other legal barriers to entry) can restrict
labour supply and force average pay and salary levels higher – this is particularly the case
in professions such as legal services and medicine where there are strict ―entry criteria‖ to
the professions.
5. Improvements in the occupational mobility of labour: For example if more people are
trained with the necessary skills required to work in a particular occupation.
Wage
Rate
Employment
Labour Supply
W1
D1
E1
W2
D2
E3
W3
Wage
Rate
EmploymentE1 E2
LS1
E2
W1
LS2

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6. Non-monetary characteristics of specific jobs – include factors such as the level of risk
associated with different jobs, the requirement to work anti-social hours or the non-
pecuniary benefits that certain jobs provide including job security, opportunities for
promotion and the chance to live and work overseas, employer-provided in-work training,
employer-provided or subsidised health and leisure facilities and other in-work benefits
including occupational pension schemes.
7. Net migration of labour – the UK is a member of the European Union single market that
enshrines free movement of labour as one of its guiding principles. A rising flow of people
seeking work in the UK is making labour migration an important factor in determining the
supply of labour available to many industries – be it to relieve shortages of skilled labour in
the NHS or education, or to meet the seasonal demand for workers in agriculture and the
construction industry.
Elasticity of labour supply
The elasticity of labour supply to an occupation measures the extent to which labour supply
responds to a change in the wage rate in a given time period. In low-skilled occupations we expect
labour supply to be elastic. This means that a pool of readily available labour is employable at a
fairly constant market wage rate. Where jobs require specific skills and lengthy periods of
training, the labour supply will be more inelastic because it is hard to expand the workforce in a
short period of time when demand for workers has increased.
In many professions there are artificial barriers to the entry of workers. Examples include Law,
Accountancy and Medicine. The need for high level educational qualifications makes the supply of
newly qualified entrants to these occupations quite inelastic in the short run and is one reason why
these workers may earn a higher real wage than average salaries.
Wage
Rate
Employment
Labour Supply
(short run)
W1
D1
E1
W2
D2
Labour
Supply
(long run)
E3
a
b
W3
c
Wage
Rate
Employment
D1
D2
E1 E2
Inelastic and elastic labour supply curves A perfectly elastic labour supply curve
Labour
Supply

- 131 -
Equilibrium wages
Wage Differentials
There is a wide gulf in pay and earnings rates between different occupations in the UK labour
market. Even in local labour markets there will be variations in pay levels – for example, in London
bus drivers working for different bus companies can see differences in their basic pay of up to
£6,000 a year?
No one factor explains the gulf in pay that exists and persists between occupations and within each
sector of the economy. Some of the relevant factors are listed below
1. Compensating wage differentials - higher pay can often be some reward for risk-taking
in certain jobs, working in poor conditions and having to work unsocial hours.
2. Equalising difference and human capital - in a competitive labour market equilibrium,
wage differentials compensate workers for (opportunity and direct) costs of human capital
acquisition. There is an opportunity cost in acquiring qualifications - measured by the
current earnings foregone by staying in full or part-time education.
3. Different skill levels - the gap between poorly skilled and highly skilled workers gets wider
each year. One reason is that the market demand for skilled labour grows more quickly
than the demand for semi-skilled workers. This pushes up pay levels. Highly skilled workers
are often in inelastic supply and rising demand forces up the "going wage rate" in an
industry.
Real
Wage
Rate
Employment
W1
Real
Wage
Rate
Employment
D2
D1
E2 E1
The equilibrium price of labour (market wage rate) in a given market is determined by the interaction
of the supply and demand for labour. Employees are hired up to the point where the extra cost of
hiring an employee (their wage) is equal to the addition to sales revenue from hiring them, their MRP.
Labour
Supply
D1
E1
Labour
Supply
W1
W2
D3
W3
E3

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4. Differences in labour productivity and revenue creation - workers whose efficiency is
highest and ability to generate revenue for a firm should be rewarded with higher pay. City
economists and analysts are often highly paid not least because they can claim annual
bonuses based on performance. Top sports stars can command top wages because of
their potential to generate extra revenue from ticket sales and merchandising.
5. Trade unions and their collective bargaining power - unions might exercise their
bargaining power to offset the power of an employer in a particular occupation and in doing
so achieve a mark-up on wages compared to those on offer to non-union members
6. Employer discrimination is a factor that cannot be ignored despite over twenty years of
equal pay legislation in place
Sticky wages in the labour market
Economists often refer to the existence of “sticky wages.‖ In a fully flexible labour market, a
decrease in the demand for labour should cause a fall in wages and a contraction in employment -
just like any demand curve shifting down.
However, sticky wages refers to a situation in which the real wage level doesn't fall immediately,
partly because most employees have wages specified in employment contracts that cannot be
re-negotiated immediately, and because workers (perhaps protected by their trade unions) are
resistant to cuts in nominal wages. If the wage level cannot fall when demand falls, it leads to a
much bigger drop in employment and, more importantly, involuntary unemployment because of
a failure of the labour market to clear.
The evidence for sticky wages is a good counter-argument to neo-classical models of the labour
market that suggest that real wage levels respond flexibly to any changes in labour demand and
supply conditions
Real
Wage
Rate
Employment
W1
Real
Wage
Rate
Employment
Ld
E1
Ls
W2
E2
Ls
Ld

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Government policies and the labour supply
The main policies designed to increase the supply of labour available to the economy are as
follows:
1. Reforms to the system of direct taxation: In the 1980s, Thatcherite economics focused
on cutting income tax rates particularly at the top end and switching away from direct
towards indirect taxation. More recently, successive governments have tended to focus
more on reductions in the lower rates of income tax and tax allowances for lower-paid
workers. The theoretical idea remains broadly the same, that lower direct taxes increase
the post-tax reward to working and act as an incentive for more people to join the labour
supply. In 2007 the government announced that the 10% starting rate of income tax would
be withdrawn in 2008 and that the basic rate of tax would be cut from 22% to 20%.
2. Reforms to the benefits system: The emphasis here has changed away from the rather
crude idea of cutting the real and relative value of welfare benefits towards encourage
people into searching for work, towards a reliance on tax credits (for example the Working
Families Tax Credit) to give parents with children a greater financial incentives to work. The
aim is to reduce the disincentive problems created by the unemployment and poverty trap.
3. Increased investment in education and training: This is designed to boost the human
capital of the labour force and improve the occupational mobility of the labour force to
meet the changing demands of employers across different industries.
4. A more relaxed approach to labour immigration: Particularly where there are shortages
of workers with skills such as consultants and fully trained nurses in the NHS, or shortages
of teachers in certain subjects. The effect of net inward migration on the labour supply is
shown in the diagram below.
Real
Wage
Rate
Employment
Labour Supply
W2
E1
W1
Labour
Demand
Labour
Supply
with
migration
E2
Strong inflows of labour into the economy can
have the effect of increasing the labour supply
This puts downward pressure on real wages
(for a given level of labour demand) e.g.
through helping to relieve labour shortages in
particular industries and occupations
If migration provides a boost to the labour
supply and to labour productivity, there is the
prospect of an outward shift in a country‘s long
run aggregate supply

- 134 -
The work-leisure trade off
Once somebody has entered the labour force how many hours will they choose to work?
For many people, the hours they work are fixed by their employers and they have little or no
flexibility in the total number of hours they supply. But the majority of workers have an opportunity
at some point to work additional hours, or perhaps switch from a full-time job to a part-time
position. And the official data probably understates the true number of people who are
―moonlighting‖ and working in a second or third job because of the expansion of the shadow
economy which had encouraged the expansion of a shadow labour force.
Often employers adjust the number of hours of work available to meet their employees‘
preferences. Over seven million people are now in part-time employment and much of this growth
in part-time jobs has been sustained because it meets the preferences of people looking for
greater flexibility in their working arrangements.
Economic theory would suggest that the real wage is a key determinant of the number of hours.
The real wage is the money wage rate adjusted for changes in the price level and it measures the
quantity of goods and services that can be bought from each hour worked. An increase in the real
wage on offer in a job should lead to someone supplying more hours over a given period of time,
although there is the possibility that further increases in the wage rate might have little effect on an
individual‘s labour supply. Indeed, there is the possibility of a backward-bending individual labour
supply curve. This is illustrated in the next diagram.
Two distinct individual labour supply curves are shown. In the first curve, higher real wages do lead
to an increase in the number of extra hours supplied, although the rate at which the individual is
prepared to give up their leisure time and work longer hours diminishes as the real wage rises. But
the labour supply curve meets the standard prediction that higher wages attract people to work
longer hours. In the second curve, for most of the range of real wages, the same prediction holds
true, but when as real wages step upwards, eventually an individual may choose to actually work
fewer hours (ceteris paribus) giving us what is sometimes termed a “backward bending” labour
supply curve.
Real
Wage
Rate
Hours of Work
Supplied (LS)
Individual Labour
Supply (1)
Individual Labour
Supply (2)
L1 L3 L2

- 135 -
Income and substitution effects
To understand why this might happen we consider the income and substitution effects that arise
from a change in the real wage being paid to an individual worker. We start with the income effect.
o The income effect: Higher real wages increase the income that someone can earn from a
job, but they also mean that the hours of work needed to earn enough to pay for a product
declines. Higher pay levels mean that a target real wage can be achieved with fewer hours
of labour supply. So this income effect might persuade people to work less hours and enjoy
extended leisure time.
o The substitution effect: The substitution effect of a higher wage rate should
unambiguously give people an incentive to work extra hours because the financial rewards
of working are raised, and the opportunity cost of not working (measured by the wages
given up when people opt for leisure instead) has increased.
With the income and substitution effects working in opposite directions, there is no hard and fast
prediction about whether people will choose to increase their labour supply as real wages increase.
Are the income and substitution effects different for male compared to female workers? What
about younger workers entering the labour market for the first time who are looking to save to
finance a deposit on a house or to fund other major items of spending? How might people closer to
retirement age respond to changes in real wages? What of workers in households where at least
someone else is in paid employment compared to a household where there is only one main
―breadwinner‖?
The available evidence for the UK labour market is mixed, indeed some analysts believe that in
aggregate, the income and substitution effects effectively cancel each other out so that real wages
have no impact on the individual labour supply!
The importance of incentives
Incentives are important in affecting the labour supply. Most of us rely on income from our work to
pay for the things we need and higher pay and better conditions should be an incentive perhaps to
work some extra hours or search for work in the first place. But for many workers there are
disincentives to supply their labour – and these problems often affect people in lowly paid jobs.
This is known as the problem of the poverty trap and there is a good example in the mini case
study below.
The Poverty Trap worsens in Scotland
The soaring cost of child care is worsening the poverty trap according to a new report
commissioned for the save the Children Fund in Scotland. More than one quarter of Scots parents
on low incomes cannot work full time because of the cost of registered childcare which has risen
by more than 10 per cent this year across most of the country. Joanne Brady, a single mother of
two children from Glasgow, is unable to work because she loses more in means-tested child tax
credits than she gains in income. ―They take 20 per cent off for each child when you go to work.
You still have to pay your housing, travel and lunches and it's just not adequate.‖ Ms Brady, 27, is
among the 28 per cent of parents with children under 18 and an income of less than £15,000.
Source: News reports, July 2008

- 136 -
Suggestions for further reading on labour demand and labour supply
Each of these articles has been selected because it is relevant to the ideas discussed in this
chapter on the demand for and supply of labour in different labour markets and how this can affect
wages and employment.
Labour Demand
Airline Qantas to cut 1,500 jobs (BBC news, July 2008)
New biomass power station will create 500 jobs (BBC news, July 2008)
Rising oil price creating new dive jobs (BBC news, July 2008)
US bosses shed thousands of jobs (BBC news, July 2008)
Labour Supply
Carers need help to get to work (BBC news, July 2008)
Farmers fear strawberry shortage (BBC news, May 2008)
The factors pulling migrant workers home (BBC news, July 2008)
Wages and Wage Differentials
Bus drivers demand equal pay rate (BBC news, July 2008)
Female workers win in pay ruling (BBC news, July 2008)
Government and Unions clash over public sector pay (BBC news, April 2008)
Hard Rock wages below the minimum (BBC news, July 2008)
Living wage to meet rising costs (BBC news, July 2008)
Migrant worker paid £8.80 a week (BBC news, June 2008)
TUC calls for minimum wage for trainees (TUC, August 2008)
Government Policies toward Work Incentives
Back to Beveridge (The Times, July 2008)
Claimants to work for benefits (BBC news, July 2008)
Migrant workers leave the UK (BBC Politics Show, June 2008)
UK growth boosted by immigration (BBC news, December 2007)

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25. Monopsony in the Labour Market
With increasing frequency these days we read in the media of stories of people – often in low paid
jobs – who claim that they are being underpaid for the job that they do. There are many possible
reasons for this and one of them is the effect of an employer using their monopsony power. This is
the focus of this chapter.
Monopsony
A monopsony producer has buying power in the labour market when seeking to employ extra
workers and may use that buying-power to drive down wage rates.
The monopsonist knows that they face an upward sloping labour supply curve, in other words, to
attract more workers in their industry, they must pay a higher wage rate – so the average cost of
employing labour rises with the number of people taken on. Because the average cost of labour
is increasing, the marginal cost of extra workers will be even higher, since we assume that an
increase in the wage rate paid to attract one extra worker must also be paid to existing workers.
The profit maximising level of employment is where the marginal cost of labour equates with the
marginal revenue product of employing extra workers. In the diagram, Eq workers are taken
on, but the monopsonist can employ these workers at an average wage rate of Wq – a pay level
below the marginal revenue product of the last worker. In this sense, the monopsonist is exploiting
labour by not paying them the full value of their marginal revenue product.
Trade unions may seek to counter-balance the monopsony power of an employer by controlling
aspects of the labour supply and by using whatever collective bargaining power they possess to
negotiate wages higher without being at the expense of employment levels.
Wage
Rate
(W)
Demand = MRPL
Labour
Supply
(ACL)
Wq
Eq
Marginal Cost of
Labour (MCL)
MRPL
A monopsony is a market dominated by a single buyer. A monopsonist has the market power
to set the price of whatever it is buying (from raw materials to labour inputs)

- 138 -
Examples of monopsony employers
Good examples might be the major employer in a small town (e.g. a car plant, a major supermarket
or the head office of a bank); nursing homes as employers of care assistants, big restaurants or
pubs in a local town. The government can also have monopsony power as the major employer in
the teaching profession or the NHS (the third largest employer in the world behind the Indian
Railways and the Chinese Red Army!
How might a minimum wage impact on employment and wage decisions of a monopsony?
Because the minimum wage is a pay floor, the monopsonist cannot pay a wage below it, so the
NMW effectively becomes the marginal and average cost curve for hiring workers up to
employment level Emin. Thereafter to hire additional staff, the wage rate must be bid up, again
creating a divergence between the average and marginal cost of labour. The effect on the diagram
is that with an appropriately set rate, the profit maximising level of employment after a minimum
wage is higher (E2) and the wage rate paid to labour has also increased (W2). So in this example,
making certain assumptions, a minimum wage might actually boost total employment and secure
better pay for workers in occupations and industries where there is some monopsonistic power
among the buyers of labour.
For some industries it has been an important counter-weight to employers who routinely pay low
wages. A study for the British Retail Consortium published in the summer of 2007 found that 96 per
cent of workers in the UK hospitality industry and 75 per cent of retail and wholesale workers
earned only the basic minimum wage, which rose from £5.35 to £5.52 an hour in October 2007.
Suggestions for further reading on monopsony power in the labour market
Union warning on migrant ‗slave labour‘ (BBC news, November 2007)
Give me a fair and decent wage (BBC news, April 2008)
Firm accused of shocking abuse (BBC news, April 2008)
Gangmaster‘s licence is revoked (BBC news, May 2008)
Thousands accused by gangmasters (BBC news, June 208)
Wage
Rate
(W)
Demand =
MRPL
Labour
Supply
(ACL)
Wq
Eq
MRPL
National
Minimum Wage
Marginal
Cost with
NMW
NMW
E2 Employment of Labour (E)

- 139 -
26. Discrimination in the Labour Market
Employers may not treat workers, be they actual or potential employees in the same way – in
which case discrimination is said to occur. It is a possible cause of market failure and we consider
different aspects of labour market discrimination in this chapter.
What is discrimination?
Nobel-prize winning economist Kenneth Arrow has defined discrimination as “the valuation in the
market place of personal characteristics of the worker that are unrelated to worker productivity”.
These personal characteristics may be sex, race, height, appearance, age, national origin or
sexual preference – or indeed any other identifiable characteristic.
Discrimination is a cause of labour market failure and a source of inequity in the distribution
of income and wealth and it is usually subject to government intervention e.g. through regulation
and legislation.
Discriminatory treatment of minority groups leads to lower wages and reduced employment
opportunities, including less training, more job insecurity and fewer promotions. The result is that
groups exposed to discrimination earn less than they would and suffer a fall in relative living
standards.
Why does discrimination occur in the labour market?
1. The 'Taste' Model (Gary Becker) - Discrimination arises here because employers and
workers have a ‗distaste‘ for working with people from different ethnic backgrounds or final
customers dislike buying goods from sales people from different races i.e. people prefer to
associate with others from their own group. They are willing to pay a price to avoid contact
with other groups. With reference to race, this is equivalent to racial prejudice.
2. Employer ignorance – Discrimination arises because employers are unable to observe
directly the productive ability of individuals and therefore characteristics such as gender or
race may be used as ‗proxies‘ – the employer through ignorance or prejudice assumes that
certain groups of workers are less productive than others and is less willing to employ
them, or pay them a wage or salary that fairly reflects their productivity, experience and
applicability for a particular job.
3. Occupational crowding effects – Females and minorities may be crowded into a cluster
of lower paying occupations.
Discrimination against female workers - the “gender pay gap” in the UK
There is little doubt that a permanent gap exists between average pay rates for females and males
in the UK labour market. However there is evidence that this gap is closing albeit slowly. A report
by the Women and Work Commission released in February 2006 found that women in full-time
work were earning 17% less than men. The gender pay gap is not confined to the UK. Average
earnings for women in the European Union are 15% less than men. In America, the difference in
median weekly pay is around 20%. Evidence of the gender pay gap comes each year from the
New Earnings Survey.
1. Hourly earnings: Since 1999 women‘s hourly earnings have remained at just over 80 per
cent of men‘s earnings. The average hourly wage rate for men in 2003 was £12.88 while
the rate for women was £10.56.
2. Weekly earnings Average weekly earnings of full-time employees in 2003 for women
(£396.0) were 75.4 per cent of those for men (£525.0). Women's weekly earnings were
lower than men's partly because they worked on average 3.5 fewer hours per week

- 140 -
Britain's equal pay record is poor when compared to other European countries - tenth out of fifteen
countries surveyed. Over a lifetime, the gender pay gap can cost a childless mid-skilled woman
just under £250 000
What factors explain the gender pay gap in the UK?
1. Human capital: i.e. there are differences in educational levels and work experience
between males and females. This is most marked when one compares married males with
married females. Breaks from paid work, including time to raise a family, also impact on
women's level of work experience. It is calculated that a mid skilled mother of two, loses an
additional £140 000 of her potential earnings after childbirth.
2. Part-time working: a significant proportion of women work part-time and part-time work
typically pays less well than full-time jobs. Nearly 50% of women in the UK whose youngest
child is under 5 are not in employment and of those who do work, 65% work part-time.
3. Travel patterns: on average, women spend less time commuting than men with the result
that they will have a smaller pool of jobs to choose from. It may also result in lots of women
wanting work in the same location near to where they live which will result in lower
equilibrium wages for those jobs.
4. Occupational segregation: women's employment tends to be concentrated in certain
occupations. Indeed, indeed 60 per cent of working women work in just 10 occupations.
Occupations which are female-dominated are often relatively poorly paid jobs (e.g. Caring,
Cashiering, Catering, Cleaning and Clerical jobs) and there is continued under-
representation in higher paid jobs within occupations – the so-called "glass ceiling" effect.
5. Employer discrimination: Work by the LSE calculates that up to 42% of the gender pay
gap is attributable to direct discrimination against women. Since 1995 the number of equal
pay cases registered with employment tribunals has more than doubled.
6. The effects of monopsony power: Females may be relatively geographically immobile
(because they are tied to their husbands' place of employment) and may be paid less than
a competitive wage by a monopsonist employer.
A reduction in the demand for female labour relative to male labour will result in a reduction in the
employment of females and a reduction in the relative wages of females compared to males
(assuming that supply of female labour is not perfectly elastic.)
Government Intervention to reduce the gender gap
Intervention has taken several forms. The Equal Pay Act introduced in 1970 sought to provide
legal protection for female workers and encouraged employers to bring the pay for males and
females into line. The Sex Discrimination Act of 1975 outlawed unequal opportunities for
employment and promotion in the workplace because of gender and it set up the Equal
Opportunities Commission.
Attention has switched in recent years away from legislation towards encouraging more women to
stay on in further and higher education providing and targeted assistance for single parents to find
work and thereby increase the labour market participation ratio among female workers.
Earnings Differentials between Ethic Groups
Ethnic minority groups in the UK are more likely to experience unemployment than White Irish or
White British groups. Despite sustained, record low unemployment among the white population at
4.4 per cent, among black and Asian people unemployment is two and half times greater at 11.3
per cent. And in terms of their earnings from the labour market, ethnic minority workers in Britain
are over-represented in low-paying occupations such as service industries, which employ
three-quarters of ethnic minority male employees and self-employed work compared to around
three-fifths of white men. Fifty-two per cent of male Bangladeshi employees and self-employed
work in the restaurant industry, compared to only 1 per cent of white men. High proportions of

- 141 -
Indian and Pakistani women work in the retail trade, another low-paying sector. Occupational
segregation is one reason for persistent earnings differentials between whites and non-whites in
the UK labour market.
Ethnic minorities face two kinds of discrimination in the UK labour market:
1. Less access to higher status occupations than their white counterparts
2. Lower pay for a given job. The latter effect is the more powerful, accounting for a five
percentage point difference between white and ethnic minority wages.
Theory of labour market discrimination
We can model the effects of discrimination using a simple labour demand and supply framework
It is difficult to be precise about the effects of discrimination in the labour market. Employers rarely
have full information about the productivity of all of their workers, let alone prejudiced or ignorant
views about the relative merits and de-merits of different groups. Increasingly employers‘
organisations along with trade unions are working hard to break down barriers to the employment
of different minority groups and in highlighting instances of discriminatory behaviour. The issue of
labour market discrimination will remain with us for many years. It is closely linked to the issue of
labour migration and in particular, the risks of discrimination of the many thousands of workers
from Eastern Europe who have come into the UK either on a temporary or permanent basis now
that twelve countries have joined the European Union.
Suggestions for reading on labour market discrimination and inequality
UK gender equality 'long way off' (BBC news, July 2007)
EU gender pay gap 'not narrowing' (BBC news, June 2007)
New age discrimination laws come into force (BBC news, July 2006)
Millions in wrong job says poll (BBC news, March 2008)
Ee Em
Wm
We
EeEd
Wd
We
Employment of White malesEmployment of Non-White Females
Wage
Supply
MRPL
MRPL Dis
Supply
MRPL
MRPL Wm
If employers are prejudiced about the relative productivity of different groups of workers, this will be
reflected in their estimates of the marginal revenue productivity of each group. The MRPL of
discriminated groups is lower than for other groups.
This is reflected in lower relative wages and a lower level of employment
Wage

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27. Trade Unions in the Labour Market
Trade Unions
Trade unions are organisations of workers that seek through collective bargaining with
employers to protect and improve the real incomes of their members, provide job security, protect
workers against unfair dismissal and offer a range of other work-related services including support
for people claiming compensation for injuries sustained in a job.
o Association of Flight Attendants (AFA)
o Association of Teachers and Lecturers (ATL)
o Bakers, Food and Allied Workers Union (BFAWU)
o Communication Workers Union (CWU)
o Fire Brigades Union (FBU)
o National Union of Journalists (NUJ)
o National Union of Teachers (NUT)
o Prison Officers Association (POA)
o Professional Footballers Association (PFA)
o Transport and General Workers' Union (T&G)
Main roles of unions
o Improve the real incomes of their members
o Lobby for better working conditions and pensions
o Provide job security
o Protect their workers against unfair dismissal
o Provide a counter-balance to the monopsony power of some employers
o Support people claiming compensation for injuries sustained in a job
o Protect workers against possible employment-related discrimination
Union Membership Trends
1. There has been a long term decline in union membership. In 2007, less than 30 per cent of
people in a job in the UK were members of a trade union
a. Only one in six private sector employees in the UK were union members in 2006
b. Almost three in five public sector employees in the UK were union members
c. Around one third of workers say that their pay and conditions are influenced by
trade union collective bargaining
d. The hourly wages of union members averaged £12.43 in 2006, 16.6% more than
the earnings of non-members (£10.66 per hour).
e. Nearly 60 per cent of people working in education are members of a trade union but
only 6 per cent of people in hotels and restaurants and only 11 per cent of people
working in wholesale, retail and motor trades
f. Only one worker in five in manufacturing industry is a member of a union
g. Only one worker in ten aged between 16-24 years is a trade union member
2. Unions now have significantly less power and influence to determine pay and conditions
than twenty years ago although in some industries (including postal workers, railway

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worker, fire fighters and prison officers) unions are still prepared to exert their ―industrial
muscle‖.
3. Under new legislation, employers must recognise a union in pay and employment
discussions when a majority of the workforce want to be represented and has voted for it.
But there is little evidence that union members secure any significant wage ―mark-up‖ or
greater job protection than people in non-union jobs
4. In current times, employers have less incentive to fear unions (many work in partnership
with businesses) but individuals have less incentive to belong since inflation is low and the
economy is strong
5. The number of active trades unions has declined by over 40% between 1990 and 2005 –
there have been a number of mergers.
Why has union membership declined?
1. Many people no longer believe that union membership is worth their while
a. Low inflation means less pressure for higher pay to protect real incomes
b. Tougher employment laws make it harder for unions to strike
c. Perception that trade unions have lost some of their relevance
2. Changes to the nature of the UK labour market
a. Increased number of people working part-time or flexi time
b. Shift towards shorter employment contracts
c. Decline in the number of jobs in heavy industry (de-industrialisation)
3. Some employers have resisted having trade unions in their workplace – or prefer to deal
only with one or two unions on pay and other issues
Trade union power
Unions have less power and influence in the labour market than they did two decades ago
although in several big industries they can still exert their ―industrial muscle‖. Power has gradually
ebbed away for a variety of reasons:
1. Employment legislation which has outlawed illegal strikes, given employers the right to
seek compensation for the effects of certain forms of industrial action and requires all
unions to hold secret ballots of their members before any strike action is permitted
2. The effects of increased competition in product markets – in nearly every domestic
market for goods and services, there is greater competition than there was a few years ago.
Be it the intensity of global competition from lower-cost producers or the deregulation of
markets that has increased market contestability, trade unions have had to adjust to a world
where the pricing power of manufacturers and service industries has been severely
curtailed. Hence the increasing demands from businesses to link pay and conditions to
worker productivity. There are still some fairly militant trade unions around – notably in the
public sector services including transport. The train drivers‘ union, ASLEF, has been one of
the more militant unions in recent years, conducting strikes on the rail network and London
Underground.
3. Patterns of employment: There has been a long term change in the structure of
employment in the British economy away from traditionally strong union sectors such as
heavy engineering, coal-mining, steel and textiles, towards service sector jobs in the private
sector where union density is much lower
Unions and wage negotiations – labour market theory

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Unions might seek to exercise their collective bargaining power with employers to achieve a
mark-up on wages compared to those on offer to non-union members. For this to happen, a union
must have some control over the labour supply available to an industry. In the past this was
possible if a union operated a closed shop agreement with an employer – i.e. where the
employer and union agreed that all workers would be a member of a particular union. However in
most sectors, the closed shop is now history – outlawed by legislation.
More frequently, a union may simply bid for better pay through bi-lateral negotiations with
employers to achieve an increase in wages ahead of the rate of inflation so that real wages rise,
and other improvements to working hours and conditions.
The balance of power between employers and a trade union in their periodic wage negotiations
depends on a range of factors including:
1. Unemployment: when labour is scarce and there are shortages of skilled workers, then the
balance of power tilts towards unions. Unions are always less powerful when the demand
for labour is falling and labour is less scarce.
2. Competitive pressures in product markets – when a firm is enjoying a dominant
monopoly position and high levels of abnormal profit, the unions will know that the employer
has the financial resources to meet a more generous wage settlement
The conventional case against trade unions
1. Unions act as a distortion in the workings of the labour market
2. They drive wages higher and profits & employment lower than if the labour market was fully
competitive
Wage
Rate
Employment
Labour Supply (union
controlled)
E1E2
Labour
Demand
W1
W2
Employment
Labour Supply (union
controlled)
E1E2
Labour
Demand
Labour
Supply to
the
Economy
W1
W3
Elastic labour demand – union control of
labour supply forces wages higher – but
employment contracts
Inelastic labour demand – unions may be
more effective in negotiating higher pay
levels and increasing total factor earnings

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3. They may prevent the introduction of new, flexible work practices
4. They may delay the introduction of new technology which thus affects productivity
5. Their collective bargaining power can lead to higher wages and cost-push inflationary
pressures which leads to a worsening of macroeconomic performance
6. Unions can cause labour market failure such as real-wage unemployment
Counter-arguments
1. The new ‗partnership model‘ between employers and unions
a. Unions and their members stand to gain from
i. Higher productivity
ii. The workforce having more flexible skills
iii. Improved working conditions and employment rights
2. Higher pay does not automatically lead to fewer jobs
i. Monopsony argument (see previous page)
ii. Higher pay can create incentives for higher productivity and working more
hours
3. Keynesian effects of increased incomes on consumer demand for goods and services –
rising aggregate demand – leading to a boost to short run economic growth
4. Trade unions have modernised to reflect changes in the domestic and global economy
5. Their role is becoming ever more important
a. Threats to the stability and future of occupational pensions
b. Persistent discrimination in the labour market (gender glass ceilings, age, ethnicity)
6. They can work with management and employers to improve efficiency and
competitiveness – and therefore achieve a positive sum game
7. There has been a step change in industrial relations in the UK – which has made the UK
economy a favoured venue for inflows of foreign direct investment – there are far fewer
industrial stoppages and days lost from strike action (see the chart below)
Suggestions for further reading on trade unions in the labour market
Guardian special reports on trade unions

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28. The Distribution of Income and Wealth
In this chapter we consider the scale of income and wealth inequalities in the UK. Why does
inequality happen? And what policies have been applied to affect the final distribution of income?
Income and Wealth
o Income is a flow of factor incomes such as wages and earnings from work; rent from the
ownership of land and interest & dividends from savings and the ownership of shares
o Wealth is a stock of financial and real assets such as property, savings in bank and
building society accounts, ownership of land and rights to private pensions, equities, bonds
etc
Absolute poverty
Absolute poverty measures the number of people living below a certain income threshold or the
number of households unable to afford certain basic goods and services. What we choose to
include in a basic acceptable standard of living is naturally open to discussion.
Relative poverty
Relative poverty measures the extent to which a household‘s financial resources falls below an
average income level. The official poverty line is drawn at an income of 60% of the median level.
Although living standards and real incomes have grown because of higher employment and
sustained economic growth, there is little doubt that Britain has become a more unequal society
over the last 20-25 years.
Measuring inequality – the Lorenz Curve and the Gini Coefficient
We measure the distribution of income and wealth by using concepts such as the Lorenz Curve
and the Gini Coefficient.
The further the Lorenz curve lies below
the line of equality, the more unequal is
the distribution of income. There are
problems with the Lorenz curve –
particular if we are inaccurate in our
measure of incomes.
The Gini Coefficient is derived from the
same information used to create a Lorenz
Curve. The Gini Coefficient can take
values from 0 to 100 per cent where a
value of zero would indicate that each
household had an equal share of income,
while higher values indicate greater
inequality.
The chart below shows the trend in the
Gini Coefficient for original and
disposable incomes of UK households
since the late 1970s. Inequality of
disposable income was fairly stable in the first half of the 1980s then increased during the second
half of the 1980s. Inequality was relatively flat in the 1990s but with some indications of a slight fall
in the first half of the 1990s and a slight rise since then. In 2001-02, the Gini coefficient was back to
its 1990 level.
THE LORENZ CURVE
%ofincomecumulative
Distribution of households
0%
100%
50%
Poorest
20%
Middle
20%
Richest
20%
Line of perfect equality

- 147 -
Percentage shares of household income and Gini coefficients, 2005
Percentage shares of income
Original Gross Disposable Post-tax
income income income income
Quintile group (20%)
Bottom 3 7 8 7
2nd 8 11 13 12
3rd 15 16 17 16
4th 24 23 22 22
Top 50 43 41 43
All households 100 100 100 100
Decile group
Bottom decile (poorest 10%) 1 3 3 2
Top decile (richest 10%) 32 27 26 27
Gini coefficient
(per cent) (Max possible is 100%) 51 36 32 36
Inequality of original income (before taking account of taxes and benefits) has followed a different
pattern. It rose fairly steadily throughout the 1980s and has been relatively stable since then. The
Gini Coefficient for disposable income is lower than for original income because of the
equalising effects of our progressive tax and benefits system.
The distribution of wealth
The distribution of wealth is more unequal than the distribution of income. The latest figures for the
UK are that over 90% of marketable wealth is in the hands of just half the population and over a
fifth of wealth is concentrated among the richest one per cent of households. Looking at global
inequalities in wealth, a study from the United Nations World Development Report published in
November 2006 found that the richest 2% of adults in the world own more than half of all
household wealth. According to the report, ―Wealth is heavily concentrated in North America,
Europe and some countries in the Asia Pacific region, such as Japan and Australia.‖
Explaining the scale of income and wealth inequality in the UK
Proportion of people whose income is below various fractions of median household
disposable income
< 60% of median income < 50% of median income
1961 12.8 7.4
1971 13.6 6.3
1981 12.1 4.5
1991 20.1 11.7
2001 17.0 9.7
2004 16.8 9.4
Source: Social Trends 36

- 148 -
There are numerous explanations both for the existence and persistence of a huge divide in
incomes and wealth within the UK. Most of them are economic in origin, but some are linked to
social change.
A summary is provided below:
(1) Differences in pay in different jobs and industries
High growth industries have enjoyed above average increases in pay and earnings. These include
(until recently) financial and business services and information technology. Jobs where labour
demand is high and there are shortages of skilled labour tend to offer more generous pay
packages for employees. In contrast, public sector service jobs have seen a decline in relative pay
levels because pay in private sector jobs has tended to out-strip earnings growth.
The worst paid jobs are still found in lower-skill service sector industries - often where there is little
trade union protection and where job insecurity is endemic.
(2) Falling relative incomes of people dependent on state benefits
State welfare benefits normally rise in line with retail prices (they are index-linked) rather than with
earnings. Therefore, households dependent on welfare assistance see their relative incomes fall
over time. This is a particular problem for many thousands of pensioner households and also for
large families on low incomes since for both groups it is widely recognised that the inflation that
they have experienced has been well above the national figure for consumer price inflation. Not
only have they fallen behind in relative terms – but their real incomes have taken a hit from the
sharp surges in food and utility bills over the last two or three years.
(3) The effects of unemployment
Unemployment is a key cause of relative poverty (i.e. an increase in income inequality). For
example, a serious problem is the increase in the number of households where no one is in paid
employment and where a family is dependent on state welfare aid. Pockets of high long-term
unemployment are nearly always associated with an increased risk of poverty. London is a good
example of this – huge wealth and deep poverty frequently live cheek by jowl.
(4) Changes to the tax and benefit system
Changes to direct and indirect taxes have contributed to an increase in relative poverty. Income tax
rates have fallen over the last two decades. The top marginal rate of tax fell from 83% in 1979 to
40% in 1988 where it has remained. The basic rate has come down from 33% in 1979 to 22%
today. These tax reductions allow people in work to keep a higher proportion of their earned
income. The benefits from lower taxes have flowed disproportionately to people on above-average
incomes because of a fall in the progressive nature of the UK‘s direct tax system.
There has been a switch towards indirect taxes in recent years including higher rates of value
added tax and higher excise duties on petrol, alcohol and cigarettes. Some of these indirect taxes
have a regressive effect on the distribution of income. A good example of this has been the real-
term increase in the level of excise duty on cigarettes and the proposed rises in vehicle excise
duty.
Policy options to change the distribution of income and wealth
There are many policy options available to a government if it wants to change the final distribution
of income and wealth in a country. The main strategies that the Labour government has chosen to
reduce poverty since it was elected in May 1997.
o The introduction of a National Minimum Wage and a series of increases in its value
o The launch of the Working Tax Credit and Child Tax Credit – designed to boost work
incentives for low-income households who opt to work full-time or part-time

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o Provision of a Minimum Income Guarantee for Pensioners and increases in the real
value of Winter Fuel Payments – designed to alleviate ―fuel poverty‖ among old people
o Active employment policies such as the introduction of New Deals for young people, the
long-term unemployed, lone parents and disabled people – a long-term strategy designed
to increase employment opportunities
In addition the government already has in place a progressive system of income tax and welfare
benefits that helps to reduce the huge differences between original and final disposable incomes
between different groups of the population.
Income redistribution through the tax and benefit system
What are the effects of the tax and benefit system on the final distribution of income in the UK?
This summary table is published each year by the Government and gives us an idea of the
progressiveness of the tax and benefits system for households in different income bands
Original income comes from wages and salaries in work, self-employment income, investment
incomes et al. To which we add entitlements to welfare benefits in cash – not that the lowest
income households are those most entitled to these benefits, some of which are means-tested.
The ratio of the original income of the richest fifth of households to the poorest fifth is 18. By the
time that government welfare benefits have been included, that ratio falls to 7.1.
Then we include the effects of direct taxation – mainly income tax and national insurance –
which acts as a progressive form of taxation – a higher income group pays a higher % of their
incomes in tax. This gives us disposable income - the ratio of the disposable income of the
richest fifth of households to the poorest fifth is 6.1.
Our final transfer is to include the effects of indirect taxes and estimated benefits in kind from state
provision of education, the NHS and housing subsidies to give a figure for final income. The final
result is that our ratio between richest and poorest quintiles falls further to 4.2.
Indirect taxes fall most heavily on poorest households. In 2001-02, they accounted for 34% of
disposable income whereas for the highest income quintile, the percentage was just 14%. This
suggests that indirect taxation overall has a regressive effect on the distribution of income in the
UK.
The government has focused its‘ policies in the following areas
o Promoting higher levels of employment
o Attempting to reduce the skills gap existing in the labour market – workers with low grade
skills are suffering badly in today‘s ever-changing labour market
o Switching towards means-tested benefits rather than universal benefits
o Offering specific financial help to certain groups
o Improving work incentives for the low paid

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There has been some limited progress in attacking some of the causes of poverty. For example the
number of children living in poor households fell by 200,000 in 2002-03. But the latest official
figures for the UK show that income inequality remains greater under Labour than under the 1979-
97 Conservative governments of Margaret Thatcher and John Major.
The Minimum Wage
The minimum wage is a price floor – employers cannot legally undercut the current minimum
wage rate per hour. This applies both to full-time and part-time workers. Labour supply and
demand curve analysis can be used to show the effects.
Evidence on the minimum wage – has it worked?
1. Employment: Since the minimum wage was introduced, unemployment in Britain has
fallen and the level of employment in the British economy is now at a record high although
the economy has avoided a recession throughout this period.
2. Inflation: In many sectors firms find it hard to pass on higher wage costs to final
consumers – limiting the inflationary effect of the minimum wage
3. Wage costs: The minimum wage affects only a small proportion of workers and the effects
on the wage bills of most businesses is not a significant factor in their employment
decisions. In the short term, the demand for labour tends to be inelastic with respect to
changes in wages
4. Discrimination: The minimum wage has had an impact on the earnings of part-time female
workers.
5. Productivity: It is hard to identify any strong positive effect on labour productivity - but
efficiency gains have been made in most low-paying industries, a trend which started
before the minimum wage was introduced.
Which policies are most effective in reducing poverty?
A government truly committed to making a serious dent in relative poverty would
o Invest more resources in skills training and life-long education for all households –
particularly those of low income families in a bid to make a real effect on child poverty
o Making the tax system more progressive – for example raising the higher rate of tax
from 40% for the top-earning households
UK Minimum Wage - Adult Rate
(for workers aged 22+)
1 Apr 1999 £3.60
1 Oct 2000 £3.70
1 Oct 2001 £4.10
1 Oct 2002 £4.20
1 Oct 2003 £4.50
1 Oct 2004 £4.85
1 Oct 2005 £5.05
1 Oct 2006 £5.35
1 Oct 2007 £5.52
1 Oct 2008 £5.73

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o Analysing carefully the effects of changes in indirect taxes such as VAT and excise duty
in case they have a regressive effect on the overall distribution of income
o Focus more on targeting benefits by means-testing them according to financial need
o Increase the value of welfare benefits / tax credits in line with the annual percentage
growth in median earnings so that the relative value of these benefits does not decline
Income tax payable: by annual income, in 2006
Number
of
taxpayers
(millions)
Total
tax
liability
(£
million)
Average
rate of tax
(percentages)
Average
amount
of tax
(£)
£4,895–£4,999 0.1 1 0.1 5
£5,000–£7,499 2.9 369 2.0 126
£7,500–£9,999 3.5 1,580 5.1 445
£10,000–£14,999 6.1 7,560 9.8 1,220
£15,000–£19,999 5.1 11,500 13.0 2,260
£20,000–£29,999 6.4 24,000 15.4 3,760
£30,000–£49,999 4.3 28,900 17.9 6,690
£50,000–£99,999 1.5 25,900 25.7 17,000
£100,000 and over 0.5 34,200 33.4 71,100
All incomes 30.5 134,000 18.2 4,390
Earning enough to live
According to a report from the Joseph Rowntree Foundation ‖According to members of the public,
a single person in Britain today needs to earn at least £13,400 a year before tax to afford a basic
but acceptable standard of living. The minimum income is above the official ―poverty line‖ of 60%
median income, for nearly all household groups. This shows that almost everybody classified as
being in poverty has income too low to pay for a standard of living regarded as ―adequate‖ by all
members of the public who took part in this research.‖
According to the report:
―A minimum standard of living in Britain today includes, but is more than just, food, clothes and
shelter. It is about having what you need in order to have the opportunities and choices necessary
to participate in society. The minimum seeks to exclude items that may be regarded as
‗aspirational‘ – it is about fulfilling needs and not wants.‖
Source: Tutor2u blog, July 2008
Taking the long view
No policies to relieve poverty are risk free. Many are highly expensive and their effects often take
many years to show through properly. The consensus among the leading academic researchers is
that high employment, and a commitment to raise the skills and potential earnings of people
towards the bottom of the pay ladder are the most effective and sustainable policies in the long
term.
Further background reading on poverty and inequality in the UK
At last, a sensible way to measure poverty (Tim Harford, Financial Times, July 2008)
Butcher guilty of low staff wages (BBC news, July 2008)
Divided Britain needs new ladder of opportunity (The Times, April 2008)

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Hard Rock wages below the minimum (BBC news, July 2008)
How the super rich just got richer (Money Programme, November 2007)
It's a rich city but it has 650,000 poor children. It's London (The Times, April 2008)
Japan sets up minimum wage raise (BBC news, April 2007)
Living on the minimum wage (BBC news audio-visual, 2006)
Mind the Gap (Guardian, January 2008)
Minimum wage rise of 3.8% stokes union anger (The Times, March 2008)
The changing face of poverty (BBC)

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29. Market Failure - Externalities
In this chapter we look at the economics of externalities and policy approaches to controlling and
correcting for externalities with a particular focus on environmental policies. Externalities are
common everywhere in everyday life but will the market – left to its own devices - take these
externalities into account? If not, then market failure can occur and there is a justification for some
form of government intervention.
Economic importance of the environment
The environment plays an essential role in shaping our economic and social welfare. The
environment
1. Provides services to consumers in the form of living and recreational spaces and the
opportunity to enjoy utility from experiencing natural landscapes and habitats.
2. It provides us with the natural resources necessary to sustain production and
consumption including the basis for renewable and non-renewable sources of energy.
3. It is a dumping ground for the waste products of our society - be it waste from
producers or from households and consumers.
The link between economic activity and our environment is fundamental. We hear constantly about
the need for sustainable welfare, for growth to take into account the direct and indirect effects on
our resources. And increasingly we, as producers and consumers, are affected by government
policies and strategies designed to promote environmental protection and improvement.
Sustainable development is that which meets the needs of the present without compromising the
ability of future generations to meet their own needs.
Externalities and the environment – the basics
For environmental economics, one of the most important market failures is caused by negative
externalities arising from production and/or consumption of goods and services.
Externalities are third party effects
arising from production and consumption
of goods and services for which no
appropriate compensation is paid. An
important point to emphasise is that
externalities occur outside of the
market i.e. they affect people not directly
involved in the production and/or
consumption of a good or service. They
are also known as spill-over effects.
One of the major problems facing the
environment is that common resources
such as fish stocks and grazing land are
not privately owned – commonly owned
resources may lack the protection of property rights and are susceptible to over-exploitation
because the marginal cost of extracting the resource for a private agent is close to zero. This is
known as the “tragedy of the commons.”
When there are environmental externalities, the private equilibrium price and quantity
determined by the interaction of market supply and demand is not the same as the social
equilibrium which includes all internal and external costs. For example, in a free market, a producer
will have little direct incentive to control pollution because it is external – i.e. the profit-maximising
supplier considers only his/her own private costs and benefits. The market failure arising from
negative externalities is shown in the diagram below. The area labelled abc is the deadweight loss

- 154 -
of welfare due to output being above the social optimum. At output levels beyond Q2, the marginal
social cost exceeds the marginal social benefit causing overall welfare to drop.
Economists argue that market failures provide a clear rationale for policy intervention to
improve efficiency. But since market failures are pervasive, intervention is only justified if the
benefits exceed the costs. As we shall see, reducing pollution is rarely, if ever, a cost-free
process.
“The Tragedy of the Commons”
The contribution of each economic agent is minute, but summed over all agents, these actions
degrade the resource and may cause severe long term damage
The ―tragedy of the commons‖ is a metaphor used to illustrate the potential conflict between
individual self-interest of producers and consumers versus the common or public good.
In the original version of the term, the example is used of a stock of common grazing land used
by all livestock farmers in a small village. Each farmer keeps adding more livestock to graze on the
commons, because the marginal cost of doing so is zero. But because the commonly-owned
resource is thus over-exploited, the result is a depletion of the soil and a fall in the value of the
resource for all users. The resource may become irretrievably damaged, an example of a public
bad.
The root cause of any tragedy of the commons is that when individuals use a public good, they do
not bear the entire social cost of their actions. If each seeks to maximize individual benefit, he or
she ignores the external costs borne by others. The absence of well-defined and legally-protected
property rights lies at the heart of the problem.
A tragedy of the commons can occur even without complete and permanent destruction of a
resource – the term can be used to describe any situation where what was perceived as a
renewable resource becomes less valuable because of over-exploitation.
Good examples of the tragedy of the commons
Burning of fossil fuels – carbon emissions – contributing to global warming
Benefits
Costs
Quantity of Output (Q)
Demand (Marginal Private Benefit) =
Marginal Social Benefit
Marginal Private Cost
Q1
Social
Equilibrium
Marginal Social Cost
Q2
a
b
c
Deadweight loss of
economic welfare
P1
Private
Equilibrium

- 155 -
Pollution of waterways - creating other externalities for users of waterways further
downstream
Logging of forests – e.g. the long-term impact on the Brazilian rain forest and the effects of
illegal logging
Over-fishing of the oceans – e.g. the current crisis in the EU fishing industry
Fly-tipping of waste products on public land
Game theory and the tragedy of the commons
The tragedy of the commons can be linked to the prisoner's dilemma that is an important part
of game theory. Individuals within a group have two options: co-operate with the group or defect
from the group. Cooperation happens when individuals agree to protect a common resource.
Defection happens when an individual decides to use more than his share of a public resource.
Cooperation has the potential to maximize every individual's benefit in the long run as the
commons are preserved and can be used indefinitely, while defection maximizes an individual's
benefit in the short run at the expense of destroying it in the long run. Thus in the case of fish
stocks, suppliers need to cooperate over a period of time so that fish stocks can start to rise again.
This is the essence of attempts to reform the European Union Common Fisheries Policy.
An alternative to regulation and taxation by government is to create a market in property rights in
order to control the impact of economic activity on the environment – for example establishing a
carbon trading emissions scheme or introduction tradable fishing permits for the EU fishing
industry.
The Economics of Waste
Waste is an inevitable by-product of production and consumption. But the economics of waste is
now a huge economic as well as social issue. The UK government wants more waste being
disposed of through incineration rather than dumped in landfill sites. It has restated its strategy
and at the top of the waste hierarchy is the aim of reducing how much waste is created in the first
place and thereby achieve a ―de-coupling‖ of waste generation from rising economic activity.
Because waste is normally regarded as a de-merit good creating external costs, there is
justification for some form of government intervention to change market prices, alter incentives and
cause a change in the behaviour of consumers and producers.
Government policy needs to be more effective in enhancing the incentives for individuals and
businesses to recycle more of their waste products.

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Hierarchy of principles of waste management:
o Prevention of waste - reduce the amount of waste created in the first place
o Reuse the product
o Recycle or compost the product
o Recover the energy by incinerating
o Disposal of the product using landfill
Government intervention to reduce market failure from negative externalities
Traditionally, policy towards the environment has concentrated in two main areas
1. Intervention in the price mechanism – for example environmental taxes and subsidies
2. Command and control measures – for example through regulations and directives
These policies are designed to:
o Achieve a more efficient use of resources.
o Promote substitution between resources (e.g. abundant for scarce, renewable for non-
renewable).
o Provide incentives for lower emissions or a change from harmful to benign emissions.
Environmental taxation
In 2008 Economist Robert Frank wrote that “When market prices convey accurate signals of cost
and value, the invisible hand promotes the common good. But prices often diverge from cost and
value and, in those cases, taxes can actually help steer resources toward more highly valued
uses.”
An environmental tax is a tax on a good or service
which is judged to be detrimental to the
environment. It may also be a tax on a factor input
used to produce (supply) that final product. The
main aim of green taxation is to
(i) Increase the private cost of producing
goods and services so that the
producer / consumer is paying for some
of the negative externalities that their
actions are creating (i.e. the
externality is internalised) – this
promotes allocative efficiency.
(ii) Raise the final cost / price of the product so that demand contracts -there is normally a
direct link between the level of output / consumption and the total pollution created.
(iii) Reduce output levels towards the estimated social optimum level of production.
(iv) Well designed environmental taxes can encourage innovation and the development
of new technologies which reduces our dependency on pollution-inefficient forms of
energy. This can help to promote dynamic efficiency.

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(v) Revenue derived from these taxes can be earmarked for lower taxes elsewhere in the
economy so that a new environmental tax is ‗revenue neutral‘ or to fund increased
spending on environmental projects.
(vi) Inter-generational equity justification: Achieving improved sustainability in our
resource use now helps to protect the resources available for future generations.
Examples of environmental taxes include: fuel duty, vehicle excise duty, air passenger duty, the
aggregates tax, the landfill tax and the London Congestion Charge. The Irish Government also
introduced a tax on plastic bags in a bid to reduce consumption and encourage recycling. The
main aim of an environmental tax is to increase the firm‘s private marginal cost (PMC) until it
equates with the social marginal cost curve (SMC).
Problems with environmental taxation
There is a growing body of economists who argue that
reliance on environmental taxation is an ineffective way
of promoting environmental improvement, indeed that
some taxes are prone to government failure. And, that
there are ways of changing the incentives of producers
and consumers through the market mechanism.
The main criticisms of environmental taxes are discussed
below:
1. Valuing the environment: There are
fundamental problems in setting taxes so that
marginal private costs will equate with the
marginal social costs. The government cannot
accurately value the private benefits and cost of
businesses let alone put a monetary value on
externalities such as the cost to natural habitat, the long-term effects of resource depletion
and the value of human life. Frequent adjustments of tax levels may be required and this
involves substantial organisational costs.
2. Consumer welfare effects: Taxes reduce output and raise prices, and this might have an
adverse effect on consumer welfare. Producers may be able to pass on the tax to the
consumers if the demand for the good is inelastic and, as result, the tax may only have a
marginal effect in reducing demand and final output.
3. Achieving a target quantity of pollution reduction: Taxes do not lend themselves to the
government achieving an accurate reduction in total pollution. This is because no
government can ever predict how consumers and or producers will respond to higher costs
and prices. The price elasticity of demand will vary over time.
4. Income distribution: Taxes on some de-merit goods (for example cigarettes) may have a
regressive effect on low-income consumers and lead to greater inequalities in the
distribution of income. Having said this, it should be possible for authorities to develop
―smart tariffs or taxes‖ where account is taken of the impact of pollution taxes on vulnerable
households such as low low-income consumers. The current Labour government has
reduced the rate of VAT on domestic fuel to the EU minimum rate of 5%, but the
government has no plans to introduce a domestic energy tax because of the huge numbers
of low-income households that currently live in fuel poverty. In the UK, the poorest 10% of
households spends 13.2% of income on energy whereas the richest spends 3.5%.
5. Employment and investment consequences: If pollution taxes are raised in one country,
producers may shift production to countries with lower taxes. This will not reduce global
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international competitiveness. Similarly, higher taxation might lead to a decline in profits
and a fall in the volume of investment projects that in the long term might have beneficial
spill-over effects in reducing the energy intensity of an industry or might lead to innovation
which enhance the environment
6. More efficient alternatives? It might be more cost effective for governments to switch
away from pollution taxation to direct subsidies to encourage greater innovation in
designing cleaner production technologies. ‗Eco-tax‘ reformers often argue that pollution
taxes should be revenue neutral – so for example, an increase in environmental taxation
might be accompanied by reductions in employment taxes such as National Insurance
Contributions so that the employment consequences of higher taxation are minimised. The
impact of green taxes depends crucially on what is done with the revenues. If they are
balanced by reducing other taxes through ‗revenue re-cycling‘, research suggests that
green taxes could result in an overall economic improvement
Suggestions for further reading on externalities and government intervention
Amazon burns once again (Guardian, October 2007)
Do smoke and drink tax rises work? (BBC news, March 2008)
Gag guzzlers to face £950 tax (BBC news, March 2008)
Paying for environmental damage (BBC news, June 2007)
Petrol taxes - Pigou or NoPigou? (Economist, November 2006)
Scrutinising climate economics (BBC, January 2007)
Taxing time to stabilise the climate (BBC news, June 2008)
Unsustainable World (BBC Newsnight special reports, Spring 2008)
US city to start charging polluting firms (BBC news, May 2008)

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30. Carbon Emissions Trading and the Stern Review
Emission trading is regarded by many as the future of environmental protection and improvement
in the UK, European and international economy. Carbon trading is another form of pollution control
that uses the market mechanism to change relative prices and the incentives of producers and
consumers. There is also growing interest in the idea of personal carbon trading, the UK
government is currently looking at the issue.
The basics of cap and trade - emissions trading
1. A fixed number of emission permits is allocated each year to polluting factories
2. Usual denomination: 1 permit = 1 tonne (e.g. of CO2 emissions)
3. Total number of permits is the limit on pollution ―the cap‖
4. Annual emissions of each factory must be less than or equal to permit holdings
5. Permits can be traded – i.e. ―cap and trade‖
6. Factories which can reduce (abate) pollution for less than the price of a permit can sell
spare ones for a profit
7. Factories which find it more expensive to reduce pollution can buy extra permits instead
8. Gradually the supply of permits is reduced – the market price rises. This gives firms who
find it expensive to cut pollution, more of an incentive to seek new technologies / process
that will reduce their pollution emissions
A marketable pollution permit gives a business
the right to emit a given volume of waste or
pollution into the environment. Ideally, the number
of permits that are issued corresponds with the
total level of pollution that is admissible at the
social optimum level of output i.e. where the MSB
= MSC. Once this has been determined the
permits are issued by auction and firms that
pollute the environment can bid for them and then
buy and sell them amongst themselves.
Pollution permits should, in theory, give firms an
incentive to control pollution emissions for less
than it would cost to buy permits, and there is
evidence from ―cap and trade‖ pollution permit
schemes in the UK and the United States that the
costs of monitoring pollution reduction and
administration of the permits system is smaller than when an industry is subject to direct regulation.
In the United States cap and trade scheme, it was found that many high-polluting businesses
invested in fitting new pollution control equipment (e.g. Flue Gas Desulphurisation) and other
polluters switched from high to low sulphur coal.
Consequently the use of marketable permits allows the cost of pollution control to be minimised.
Another advantage is that the revenue from a traded pollution permits scheme can be re-cycled
into other schemes for environmental improvement.
Incentives matter – create a market in the “right to pollute” - The basic idea behind traded
pollution permits is to through the incentive to cut pollution directly to the producers themselves.
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routes to emission reductions. In other words, market forces are brought to bear on the issue of
pollution and potential market failure.
Emission trading is likely to be most effective when
1. There is an easily measurable pollutant
2. The government sets a clearly defined and stable emissions target
3. There are a large number of participant firms, with companies sufficiently sophisticated to
deal with the technicalities of trading at auction
4. Wide variation in costs of reducing pollution so that trading of surplus permits can take
place
5. The transactions costs of trading permits are low and there is clear pollution data
availability at the start and during trading
6. Strict enforcement of permits (i.e. a high compliance rate among participating businesses)
Carbon trading and government failure
The EU's flagship carbon trading scheme may be failing to achieve the objectives set for it. Coal
production is on the increase in the UK and around Europe. But this is the sort of thing that isn't
supposed to be happening! Even with the potential for clean coal technology, it is widely regarded
as a dirty source of energy and a major contributor to C02 emissions. Why are the power stations
turning back to coal? Because the price of carbon emissions is low and coal has become price
competitive against oil and gas.
Europe's carbon trading scheme started in January 2005 with carbon allowances being bought and
sold. The largest C02 emitters were brought into the cap and trade system. The cap places a limit
on the total pot of emissions that can be released by industry - the aim is to progressively reduce
this cap over time and therefore mitigate climate change. The original caps set by the EU are now
seen as being set way too high and some people believe that this was not an accident, companies
and businesses may have been deliberately given more allowances than they needed, creating
surplus permits that could be profitably sold onto to other businesses.
Carbon Trade Watch believe that the EU has been captured by strong corporate lobbying who
themselves knowingly over-estimated their "business as usual" C02 emissions when they
submitted them to national governments ahead of the launch of the carbon trading scheme. The
surplus of C02 emission allowances has meant that scarcity in the market has disappeared leading
to a collapse in the price of carbon - prices now are 20-30 Euro cents, effectively the price of
polluting is close to zero. The market thus provides little incentive for businesses to invest money
in reducing their emissions.
For firms with plenty of surplus C02 emissions (given away free of charge in the first place!) there
has been a huge windfall gain. "Polluter pays" seems to have been replaced with "polluter earns"!
The major power generators have been given a free block of pollution rights which they can then
sell onto the market and make a profit. DEFRA, the UK environment agency has estimated that the
windfall profits for the electricity generators in the UK might have been as high as £1.5bn.
One criticism of the EU carbon trading scheme is that the EU allocated initial allowances free
rather than using a market-based auction system.
As coal production expands, so C02 emissions are rising, and the power stations have to buy extra
emissions credits, but the price of credits is low so the consequences for the power generators are
not significant. Emissions from coal fired power stations in the UK in 2006 alone increased by 8%!
Consumers are paying the price of higher energy bills but they are not getting the environmental
pay off in terms of reducing carbon production as a contribution to controlling climate change.
Adapted from Economics in the News, Tutor2u, June 2007

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Mini Case Study: Drax feels the heat of rising carbon prices
It is impossible to miss - the giant Drax coal-fired power station that straddles the A1 near
Ferrybridge in Yorkshire and dominates the landscape for miles around is the largest in Western
Europe and supplies about 7 per cent of the UK‘s electricity. Of course generating electricity from
coal necessitates plenty of carbon emissions - figures show that every six months Drax creates
nearly 10 million tonnes of CO2 and, under the terms of the EU‘s carbon trading scheme, it must
not only pay for coal but also purchase emission allowances. It has announced that the combined
cost of coal and CO2 permits has nearly doubled over the last year from £222m to £413m.
Drax was given fewer ‗free‘ emissions allowances this year and it has had to go to the carbon
market and purchase permits to emit 6.5m tonnes of CO2, compared with just 3.6m tonnes last
year. At the same time the market price of carbon has risen from £3 to £16.50.
Putting a price on carbon is a market-based strategy designed to change the incentives for
polluting businesses. If carbon trading works, it ought to provide - over time - an incentive for
polluters to invest in more pollution efficient production processes and technology.
There is some evidence that Drax is rising to the challenge - in recent months the business says
that it has refitted turbines to make its generators more efficient and also taken steps to increase
its ‗co-firing capacity‘ a process that allows the power station to burning organic matter such as
pellets made from straw to create power in alliance with coal. Their capital investment
programme is scheduled to be worth over £40m this year.
For Drax the key to operating a profitable power station is to charge a higher price to its customers
than the cost of generating the electricity. Their half year financial statement offers a window on the
challenges facing the business. In the six months to the end of June 2008 the figures were as
follows:
Average achieved price charged to electricity buyers = £53.6p per mega watt (11% higher
than at the same time last year)
Average fuel cost (excluding CO2 allowances) = £23.6/MWh (34% higher than at the same
time last year)
Average fuel cost (including CO2 allowances) = £31.8/MWh (72% higher than at the same
time last year)
Unit costs have risen much more quickly than the final output price leading to a reduction in
operating profits. Drax has been hit hard by the surging price of coal on world markets - a tonne of
coal was selling for $218 in June 2008 - driven higher by the inability of countries such as South
Africa to expand production sufficiently quickly to meet strong demand from China, India and many
other emerging market countries.
Source: Tutor2u Blog, August 2008
Kyoto
Emission trading was a key feature of the Kyoto Protocol as a strategy to address some of the
threats posed by climate change in 1997. Kyoto allows trading of permits for carbon dioxide
between industrialised countries but the United States withdrew from the agreement in 2001 and
since the USA represents 32% of emissions amongst developed countries with emission targets,
the absence of the USA from an embryonic trading system will seriously reduce demand for
permits and therefore drive down their price and effectiveness.

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Pollution regulation
Instead of relying on intervention in the market mechanism by using taxation, subsidies or pollution
permits, the government and its appointed agencies can regulate the level of output and pollution
in a market. In theory, the government could set a quota so that output is set at the social optimum.
More frequently, minimum or environmental / emission standards are widespread in many
industries. This requires regulatory bodies to monitor (inspect) and fine firms that do not meet the
standards set for water and air quality. The 1989 Environmental Protection Act for set standards on
emissions for firms that carried out chemical processes, waste incineration and oil refining.
Compliance with environmental regulations can be very costly to enforce and it may be impossible
to monitor all firms accurately because of imperfect information. Regulation also does not bring
in any direct tax revenue flows that can be used to fund environmental improvement schemes or
compensate those who have been negatively affected by pollution.
The Stern Review on Climate Change
The Stern Review is an important piece of work despite it having come under attack from various
quarters. It is a report that calls for action – so called mitigation policies – to reduce carbon
emissions now to first stabilise and then reduce the effects of climate change.
Selected quotes from Sir Nick Stern
―Global warming is the greatest market failure that the world has ever seen.‖
―What is going to happen to our climate in the next twenty or thirty years is already determined.‖
―The physical geography of the world transforms the human geography of the world.‖
The Stern Review concludes that the social cost of carbon today, if the world continues to travel
along a ‗business as usual‘ path, is much higher than the very low (and possibly zero) marginal
costs of undertaking the cheapest forms of mitigation now. It rationalises the case for action now
including the case for deep cuts in carbon emissions. Societies that choose to behave myopically
often shorten their expected lifetimes!
No laissez-faire solution
―The economics of climate change has the economics of risk and uncertainty at its core. The
unmitigated accumulation of greenhouse gases in the atmosphere poses ever-greater risks, and
the policy challenge is to find the most cost-effective, efficient and equitable way to reduce the
risks. It is worth re-emphasising that the problem is not going to be solved without international
collective action: there is no laissez-faire solution.
Source: http://www.hm-treasury.gov.uk/media/B6F/58/paper_a.pdf
According to the Stern Review, ―The world is already irrevocably committed to further climate
changes, which will lead to adverse impacts in many areas. Global temperatures, and therefore the
severity of impacts, will continue to rise unless the stock of greenhouse gases is stabilised.
Urgent action is now required to prevent temperatures rising to even higher levels, lowering the
risks of impacts that could otherwise seriously threaten lives and livelihoods worldwide.‖
A Question of Risk
Environmental policy is basically about the economics of risk – we are dealing with very long
time horizons and there are many uncertainties involved when modelling the effects of climate
change
Externalities

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Global warming is an externality pure and simple. It does not matter who creates the CO2
greenhouse gases, a tonne of Co2 is a tonne of Co2. But the effects on the physical and human
geography of the world are not equitable. Indeed Stern talks of a double inequity, 75% of
emissions come from the rich advanced nations, but the consequences of global warming will fall
disproportionately on the poorer nations, many of whom lack the resources to adapt to some of the
effects.
Measuring the social cost of carbon (SCC) social cost = private cost + external cost – the Stern
Review calculates the social cost of carbon to be $85 per tonne of CO2 and that this figure rises
over time. However, strong and effective mitigation policies can reduce the SCC to around $25-$35
per tonne of CO2
Pollution abatement – not a free lunch
Emissions reduction is not a zero cost option – we use the concept of marginal abatement cost –
i.e. the cost of reducing emissions by one tonne– acting now to cut emissions effectively imposes a
cost on current generations – that cost can be expressed in terms of lost growth through higher
prices.
The Stern Review estimates that the cost of reducing CO2 emissions along a path consistent with
stabilising the concentration of CO2 will be in the region of 1% of GDP by the middle of this century
- global GDP is likely to be around $100 trillion by 2050, so this would mean annual costs in the
order of $1 trillion by then – this figure is roughly the same amount as is spent worldwide on
advertising, and half what the World Bank estimates a full-blown flu pandemic would cost
The power of technology and innovation
Technological change arising from innovation and
invention has the power to reduce marginal
abatement costs – policy therefore needs to promote
innovation at all levels. But there is no guarantee that
relying on a laissez-faire market approach will yield
the innovations required in time.
Valuing the environment today and long distances into the future
o The effects of climate change today and the near term raise issues of intra-generational
equity
o How much economic growth needs to be sacrificed today to protect future generations?
o How should we value today the welfare of future generations?
The Stern Review chooses to give future generation equal ethical weight by choosing a very low
discount rate to value the importance of the environment to future generations.
Mitigation policies
What are the main options for mitigation – i.e. reducing emissions?
1. Put a price on carbon: An externality requires a price for emissions – this is the first task
of mitigation policy – internalise the externalities for example through the use of carbon
taxes and/or carbon trading to create the right incentives to change behaviour
2. Promote research, development and deployment of new technologies: Note here the
importance of secure property rights - since inadequate property rights can prevent

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investors reaping the full return to new ideas. Businesses need the incentive to take the risk
of sinking costs into research projects.
3. Regulate where necessary and seek to educate: Effective regulation and tough emission
standards can work and there is a key role for government to seek to deepen public
understanding of responsible behaviour.
Stern: ―the mitigation of externalities from CO2 emissions is a global public good‖ – but there are
some risks of people / countries free-riding on the positive actions of others?
Suggestions for further reading on carbon trading and the Stern Review
Airlines included in EU CO2 plans (BBC news, July 2008)
Articles on climate change from the Independent
At-a-glance: The Stern Review (BBC news, October 2006)
Australian carbon emissions plan (BBC news, July 2008)
California passes emissions law (BBC news, September 2006)
Carbon market's value hits $64bn (BBC news, May 2008)
Carbon Positive
Carbon Trade Watch
Clean Development Mechanism is working (BBC news, May 2008)
Cost of tackling global climate change has doubled, warns Stern (Guardian, June 2008)
MPs back personal carbon credits (BBC news, May 2008)
Oil sands - an environmental catastrophe (Guardian, July 2008)
Tim Harford on carbon negativity (Financial Times, July 2008)
UK‘s first emissions zone begins (BBC news, February 2008)
What is carbon trading? Can it save the world from global warming? (Independent, October 2006)

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31. Cost Benefit Analysis
In a world of finite public and private resources, we need a standard for evaluating trade-offs,
setting priorities, and finally making choices about how to allocate scarce resources among
competing uses. Cost benefit analysis provides a way of doing this.
The cost-benefit principle says that you should take an action if, and only if, the extra
benefit from taking it is greater than the extra cost
Here are some examples where the principle might be built into your analysis and evaluation
1. Costs and benefits of subsidies e.g. the bio-fuel debate or subsidies
2. Costs and benefits of the introduction of competition e.g. postal market liberalisation
3. Costs and benefits of different strategies designed to reduce income and wealth inequality
e.g. the national minimum wage or a rise in the top rate of income tax
4. Costs and benefits of the introduction of carbon trading as a way of reducing CO2
emissions
5. Costs and benefits of major infrastructural projects such as new motorways, London 2012
6. Costs and benefits of a decision to relax planning controls on new house-building
What is cost benefit analysis?
Cost benefit analysis (COBA) is a technique for assessing the monetary social costs and
benefits of a capital investment project over a given time period. The principles of cost-benefit
analysis (CBA) are simple:
1. Appraisal of a project: It is an economic technique for project appraisal, widely used in
business as well as government spending projects (for example should a business invest in
a new information system)
2. Incorporates externalities into the equation: It can, if required, include wider
social/environmental impacts as well as ‗private‘ economic costs and benefits so that
externalities are incorporated into the decision process. In this way, COBA can be used to
estimate the social welfare effects of an investment
3. Time matters! COBA can take account of the economics of time – known as
discounting. This is important when looking at environmental impacts of a project in the
years ahead
Uses of COBA
COBA has traditionally been applied to big public sector projects such as new motorways, by-
passes, dams, tunnels, bridges, flood relief schemes and new power stations. Our example later
considers some of the social costs and benefits of the new Terminal 5 for Heathrow airport.
The basic principles of COBA can be applied to many other projects or programmes. For example,
- public health programmes (e.g. the mass immunization of children using new drugs), an
investment in a new rail safety systems, or opening a new railway line. Another example might
be to use COBA in assessing the costs and benefits of introducing congestion charges for
motorists in London. Cost benefit analysis was also used during the recent inquiry into genetically
modified foods. Increasingly the principles of cost benefit analysis are being used to evaluate the
returns from investment in environmental projects such as wind farms and the development of
other sources of renewable energy, an area where the UK continues to lag behind.
Because financial resources are scarce, COBA allows different projects to be ranked according to
those that provide the highest expected net gains in social welfare - this is particularly important
given the limitations of government spending.

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Main Stages in the Cost Benefit Analysis Approach
At the heart of any investment appraisal decision is this basic question – does a planned project
lead to a net increase in social welfare?
o Stage 1(a) Calculation of social costs & social benefits. This would include calculation
of:
o Tangible Benefits and Costs (i.e. direct costs and benefits)
o Intangible Benefits and Costs (i.e. indirect costs and benefits – externalities)
o This process is very important – it involves trying to identify all of the significant costs &
benefits
o Stage 1(b) - Sensitivity analysis of events occurring – this relates to an important
question - If you estimate that a possible benefit (or cost) is £x million, how likely is that
outcome? If you are reasonably sure that a benefit or cost will ‗occur‘ – what is the scale of
uncertainty about the actual values of the costs and benefits?
o Stage 2: - Discounting the future value of benefits - costs and benefits accrue over time.
Individuals normally prefer to enjoy the benefits now rather than later – so the value of
future benefits has to be discounted
o Stage 3: - Comparing the costs and benefits to determine the net social rate of return
o Stage 4: - Comparing net rate of return from different projects – the government may
have limited funds at its disposal and therefore faces a choice about which projects should
be given the go-ahead
Evaluation: Criticisms of COBA
There are several objections to the use of CBA for environmental impact assessment:
1. Problems in attaching valuations to costs and benefits: Some costs are easy to value
such as the running costs (e.g. staff costs) + capital costs (new equipment). Other costs are
more difficult – not least when a project has a significant impact on the environment. The
value attached to the destruction of a habitat is to some ―priceless‖ and to others
―worthless‖. Costs are also subject to change over time – I.e. the construction costs of a
new bridge over a river or the introduction of electronic road pricing
2. The CBA may not cover everyone affected (i.e. all third parties) – inevitably with major
construction projects such as a new airport or a new road, there are a huge number of
potential ―stakeholders‖ who stand to be affected (positively or negatively) by the decision.
COBA cannot hope to include all stakeholders – there is a risk that some groups might be
left out of the decision process
a. Future generations – are they included in the analysis?
b. What of ―non-human‖ stakeholders?
3. Distributional consequences: Costs and benefits mean different things to different
income groups - benefits to the poor are usually worth more (or are they?). Those receiving
benefits and those burdened with the costs of a project may not be the same. Are the
losers to be compensated? To many economists, the equity issue is as important as the
efficiency argument.
4. Social welfare is not the same as individual welfare - What we want individually may not
be what we want collectively. Do we attach a different value to those who feel

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―passionately‖ about something (for example the building of new housing on greenfield
sites) contrasted with those who are more ambivalent?
5. Valuing the environment: How are we to place a value on public goods such as the
environment where there is no market established for the valuation of ―property rights‖ over
environmental resources? How does one value ―nuisance‖ and ―aesthetic values‖?
6. Valuing human life: Some measurements of benefits require the valuation of human life –
many people are intrinsically opposed to any attempt to do this. This objection can be partly
overcome if we focus instead on the probability of a project ―reducing the risk of death‖ –
and there are insurance markets in existence which tell us something about how much
people value their health and life when they take out insurance policies.
7. Attitudes to risk – e.g. a cost benefit analysis of the effects of genetically modified foods
a. Precautionary Principle: Assume toxicity until proven safe
i. If in doubt, then regulate
b. Free Market Principle: Assume it is safe until a hazard is identified
i. If in doubt, do not regulate.
8. Weighing qualitative factors such as social inclusion effects, policy integration/cohesion,
accessibility/discrimination and the ―legacy effects‖ of capital investment
Despite these problems, most economists argue that CBA is better than other ways of including
the environment in project appraisal.
Discounting the future
Would you rather have £1000 of income today or £1000 of income in the future (say in 3 years?).
The answer is probably now, because £1000 in three years time is unlikely to buy as many goods
and services as it does now (because of inflation). And also because £1000 put into a savings
account today will yield interest.
Discounting is a widely used technique as part of cost benefit analysis. The technique of
discounting reflects the following:
The value of a cost or benefit now > the value of a cost or benefit in future years
Discounting reflects this by reducing all future costs and benefits to express them as today‟s
values. The key question is: How do you choose an ‗interest rate‘ for reducing future costs to give
them a present value today?
Setting a general discount rate for new projects has important implications for the environment:
1. A low discount rate is often favoured by economists since they argue that investing a high
proportion of current income is a good way of providing for the future
2. A high discount rate may also be favoured since it discourages investment (and by
implication environmental damage) in the present
Most projects have lifetimes of 20-30 years – with many of the big costs arising early in a project
e.g. from construction whereas the stream of benefits from a project occur over a much longer
period of time. But for many huge construction projects, some of the costs only become apparent
in the long run. Consider the building of a new nuclear power station. Environmentalists would
argue that there is a long list of costs from waste management and decommissioning which stretch
over 100 years into the future whereas no social benefits exist to offset these costs beyond year 30
or 40 (where the nuclear power station might reasonably be expected to be ready for closure).

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The value of decommissioning costs over 100 years away is almost negligible no matter what
discount rate we use. This makes discounting difficult to justify
Revealed Preference – Valuing the Benefits from a Project
According to some economists, the valuation of benefits and costs used in COBA should reflect the
preferences revealed by choices which have actually been made by individuals and businesses
in different markets.
Information contained in the demand curve tells us much about how much people are willing and
able to pay for something. This is important in revealed preference theory. When consumers make
purchases at market prices they reveal that the things they buy are at least as beneficial to them as
the money they relinquish.
Cost benefit analysis in practice – Heathrow Terminal 5
The debate over whether there should be a fifth terminal at Heathrow airport has fierce and long-
lasting! The official planning enquiry reported after 5 years and having cost many millions of
pounds. The rival arguments at the inquiry highlighted many examples of environmental impact
(externalities) - noise, air quality, rivers etc. - but concluded that these were not enough to refuse
planning permission and that the new terminal project should go ahead.
The case for terminal 5
1. Economic growth: Demand for air travel in south-east England is forecast to double in the
next 20 years, making expansion vital – many thousands of jobs and businesses depend
on Heathrow airport expanding to provide sufficient supply capacity to meet this growing
demand. An increase in the capacity of Heathrow will make best use of airport's existing
infrastructure and land (nearly 3,000 acres).
2. The economy and trade: The UK will lose airlines and foreign investment to European
rivals if it does not meet demand. The benefits of a world-beating industry would be
diminished – many sectors of our aviation industry have a comparative advantage and add
huge sums to our balance of payments
3. Jobs: The terminal 5 project will create or safeguard an estimated 16,500 jobs, as well as
creating 6,000 construction jobs during the building phase – this will have multiplier effects
on the local / regional and national economy
4. Transport: The terminal will be the centre of a world-class transport interchange, with new
Tube and rail links. Car traffic would rise only slightly – the social costs of increased traffic
congestion have been exaggerated by the environmentalists
5. Environment: The site earmarked for terminal 5 is currently a disused sludge works, and
any displaced wildlife and plant life will be carefully relocated. The noise climate around
Heathrow Airport has been improving for many years, even though the number of aircraft
movements has increased considerably – partly due to the phasing out of older, nosier
aircraft
6. Noise and night flights: BAA promises no increase in overall noise levels or in night flying.
The number of flights would rise only 8%
The objections to Terminal 5
1. Growth: BAA forecasts are misleading and will lead to uncontrolled expansion, rather than
targeting better solutions such as using existing space at other airports.

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2. The economy: Heathrow already has the biggest capacity in Europe, and ambitions to
extend its lead are merely "commercial prestige" rather than having long term
macroeconomic benefits
3. Jobs: Only 6,000 jobs will be created - a tiny fraction of all the new jobs in the South East.
Local studies say jobs will increase anyway even without a fifth terminal
4. Transport: There will be a significant increase in road-widening and car parks to cater for
the tens of thousands of extra car journeys to the airport every year
5. Environment: Air pollution will increase significantly, and hundreds of acres of wildlife and
Green Belt land will be lost forever. Plus the environmental costs of increased traffic
congestion
6. Noise and night flights: More flights will mean more noise under the flight paths, and the
pressure for controversial night flights and a third runway will increase – the regulators will
be captured by the airlines and airport authorities and will eventually be pressurized into
giving way on allowing more night time flights
These are just a few of the arguments raised for and against the Terminal 5 project. For more
news on the project consult www.baa.com/main/airports/heathrow/terminal_5_frame.html
A national smoking ban
According to a cost benefit analysis performed for the Chief Medical officer's Annual Review of
Public Health published in July 2004, a ban on smoking in public places would benefit the economy
by between £2.3bn and £2.7bn a year. The COBA argued that a ban on smoking in pubs,
restaurants and cafes would not reduce profits in the leisure, catering and hospitality industry.
However critics of the new study responded by saying that the assumptions behind the economic
model, remained unpublished. The main findings of the cost benefit analysis are summarised in the
table below.
ANNUAL BENEFITS £ MILLION
Health benefits (reduced absenteeism) 70 – 140
Health benefits (reduced costs of healthcare) 4
Health benefits (averted deaths from second-hand smoke amongst
employees)
21
Health benefits (reduced uptake, particularly new young employees) 550
Health benefits (smoking cessation) 1600
Safety benefits (damage, deaths, injuries) 57
Safety benefits (cost to fire services) 0.2
Safety benefits (administration costs) 6.3
Cost savings to NHS from smoking cessation Not estimated
Cleaning costs and damage to equipment avoided 100
Production gains 340 – 680
Total 2700 - 3100
Annual Costs £ million
Production losses (smoking breaks) 430
Losses to continuing smokers (loss of satisfaction) 155
Losses to quitters (loss of satisfaction) 550
Losses to the Treasury 1145
Total

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Some of the stakeholders affected by the smoking ban include the following
Losers from the decision Winners from the decision
Dry-cleaners (smoke-free pubs mean less
need for people to launder suits and other
clothes)
Packaging companies – the demand for beer cans
has increased as more people drink at home
Specialised tobacconists Pizza delivery companies – more people ordering
take-away instead of pub meals
Bingo halls Manufacturers of outdoor patio heaters, awnings
and decking
Pubs – pub closures in the UK have run at
a net rate of 27 per week during 2008
Cigarette companies – domestic demand for
cigarettes has fallen but they have offset this by
growing sales to Eastern Europe – helped by the
falling exchange rate
A number of major infrastructural projects are planned in the UK over the coming years. Each of
them could be considered using some of the principles of cost-benefit analysis. Examples include:
1. Nuclear power plants: Expansion or renovation planned at more than a dozen nuclear
facilities, raising concerns about safety and waste disposal.
2. Reservoirs: To combat long term water supply shortages the government is planning to
expand six reservoirs in the South and South-east
3. Incinerators: New EU environmental regulations could lead to the building of three
massive, centralised disposal units for millions of tonnes of commercial and household
waste.
4. Airports and extra runways: With an extra 100m passengers predicted to be using UK
airports by 2030, there are new runways planned for four airports as part of a huge
expansion programme.
5. The Severn Barrage: Harnessing tidal power could generate up to 5 per cent of Britain's
electricity needs from the Severn Barrage alone.
6. Gas pipelines: Six huge underground gas fields built after surge in imports of liquefied
petroleum gas and collapse in North Sea supply.
7. New roads: About 500 miles of extra roads are planned together with a series of road
widening schemes
To recap, cost benefit analysis is basically an appraisal technique that tries to place monetary
values on all benefits arising from a project and then compares the total value with the project's
total cost. It has numerous potential applications although there are inherent difficulties with the
issue of valuation. Essentially the process of COBA is a comparative one, so that we can perhaps
make judgements about which projects from a limited choice should be given the go ahead.
Suggestions for further reading on cost benefit analysis
Severn barrage will be costly ecological disaster, say environment groups (Guardian, June 2008)

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