EconA2Micro200 Full

A2Economics
Microeconomics
CourseCompanion
2009

IntroductiontotheA2MicroeconomicsStudyCompanion
Welcometothis200809editionoftheTutor2uA2microeconomicsstudycompanion.Theedition hasbeenrevisedthroughoutandseekstoprovideacomprehensivecoverageofsomeofthekey ideasintheA2businesseconomicscoursestogetherwithcoverageofenvironmentalmarketfailure issuesandaspectsoflabourmarketeconomics. Thedigitalversionofthisstudycompanioncontainsmanylinkstoselectedonlineresourcessuchas recentnewsarticlesfromrecommendednewspapersandmagazine.AndalsototheTutor2u economicsblogsothatwhenyouclickonsuchalink,youwillbeguaranteedtobetakentothelatest blogfeatureswrittenafterthisstudycompanionwascompleted. ThisstudycompanionisdesignedasacomplementtoyourstudiesinA2Economicsandshouldnot beregardedasasubstitutefortakingeffectivenotesinyourlessons.Pointsraisedandissues coveredinclassanalysisanddiscussioninvariablygobeyondtheconfinesofthisguide.Andwith Economicsbeingthesubjectthatitis,eventsandneweconomicpolicydebateswillinevitably surfaceoverthenexttwelvemonthsthattakeyouintonewandexcitingterritory. Economicsisadynamicsubject,theissueschangefromdaytodayandthereisawealthof commentandanalysisinthebroadsheetnewspapers,magazinesandjournalsthatyoucandelve into.Themorereadingyoumanageonthemainissuesofthedaythewiderwillbeyourappreciation ofthetheoryandpracticeofeconomics. FurtherresourcesincludingonlinetestsandrevisionnotesareavailablefromtheTutor2uvirtual learningenvironment(VLE)athttp://vle.tutor2u.netChecktoseeifyourschoolorcollegehasa subscriptiontothisresourceandEconoMaxTutor2usdigitalmagazineforEconomics. IacknowledgethehelpgiveninthepreparationofthisstudycompanionbymyownstudentsandI alsoacknowledgesomeoftheideasandargumentsputforwardinarticleswrittenbyBobNutter,Jim Riley,LizVealandMarkJohnstonsomeofmyfellowwritersfortheEconoMaxdigitalmagazine fromwhichasmallnumberofarticleshavebeenadaptedasminicasestudies. Goodluckwithyourstudies GeoffRiley ThisstudycompanionfollowstheAQAsyllabusandchaptersaregroupedintofivemainsectors: 1. TheFirm:Objectives,CostsandRevenues 2. CompetitiveMarkets 3. ConcentratedMarkets 4. TheLabourMarket 5. GovernmentInterventionintheMarket
http://www.tutor2u.net/blog/index.php/economics/
Contents
1. 2. 3. 4. 5. 6. 7. 8. 9. ProductionintheShortandtheLongRun..................................................................................4 Howcanwecalculatethecostsofafirm?..................................................................................8 LongRunCosts:EconomiesandDiseconomiesofScale .......................................................13 . BusinessRevenues...................................................................................................................23 Profits.........................................................................................................................................26 WhatObjectivesDoFirmsHave?.............................................................................................34 DivorcebetweenOwnershipandControl .................................................................................38 . TechnologicalChange,CostsandSupplyintheLongrun ......................................................42 . TheGrowthofFirms..................................................................................................................45
10. PerfectCompetition...................................................................................................................51 11. MonopolisticCompetition...........................................................................................................59 12. TheModelofMonopoly.............................................................................................................62 13. BarrierstoEntryandExitinMarkets.........................................................................................65 14. PriceDiscrimination...................................................................................................................69 15. MonopolyandEconomicEfficiency ..........................................................................................76 . 16. CollusiveandNonCollusiveOligopoly.....................................................................................84 17. OligopolyandGameTheory .....................................................................................................90 . 18. ContestableMarkets..................................................................................................................97 19. MonopsonyPowerinProductMarkets....................................................................................101 20. ConsumerandProducerSurplus............................................................................................103 21. PriceTakersandPriceMakersPricingPower ....................................................................106 . 22. CompetitionPolicyandRegulation..........................................................................................111 23. PrivatisationandDeregulation ................................................................................................116 . 24. TheLabourMarket...................................................................................................................124 25. MonopsonyintheLabourMarket............................................................................................137 26. DiscriminationintheLabourMarket........................................................................................139 27. TradeUnionsintheLabourMarket.........................................................................................142 28. TheDistributionofIncomeandWealth...................................................................................146 29. MarketFailureExternalities...................................................................................................153 30. CarbonEmissionsTradingandtheSternReview..................................................................159 31. CostBenefitAnalysis...............................................................................................................165
1. ProductionintheShortandtheLongRun
Wetakeitforgrantedthatgoodsandserviceswillbeavailableforustobuyasandwhenweneed them.Butproductionandsupplyingtothemarketisoftenacomplicatedbusiness. ProductionFunctions Theproductionfunctionelatesthequantityoffactorinputstothevolumeofoutputsthatresult. Wemakeuseofthreemeasuresofproductionandproductivity. o Totalproductmeanstotaloutput.Inmostmanufacturingindustriessuchasmotorvehicles, motorhomesandDVDplayers,itisstraightforwardtomeasureproductionfromlabourand capitalinputs.Butinmanyserviceorknowledgebasedindustries,wheretheoutputisless tangibleorperhapsweightlesswefindithardertomeasureproductivity. o Averageproductmeasuresoutputperworkeremployedoroutputperunitofcapital. o Marginalproductisthechangeinoutputfromincreasingthenumberofworkersusedbyone person,orbyaddingonemoremachinetotheproductionprocessintheshortrun.
Thelengthoftimerequiredforthelongrunvariesfromsectortosector.Inthenuclearpowerindustry forexample,itcantakemanyyearstocommissionnewnuclearpowerplantandcapacity.Thisis somethingtheUKgovernmenthastoconsiderasitreviewsourfuturesourcesofenergy. ShortRunProductionFunction Theshortrunisatimeperiodwhereatleastonefactorofproductionisinfixedsupplyit cannotbechanged.Wenormallyassumethatthequantityofplantandmachineryisfixedandthat productioncanbealteredthroughchangingvariableinputssuchaslabour,rawmaterialsand energy. Thetimeperiodsusedineconomicsmustdifferfromoneindustrytoanother.Theshortrunforthe electricitygenerationindustryortelecommunicationsdiffersfrommagazinepublishingandlocal sandwichbars.Ifyouarestartingoutinbusinessthisautumnwithanewventuresellingsandwiches andcoffeestoofficeworkers,howlongisyourshortrun?Andhowlongisyourlongrun?(!!).The
longruncouldbeasshortasafewdaysenoughtimetoleaseanewvanandasandwichmaking machine! DiminishingReturns Intheshortrun,thelawofdiminishingreturnsstatesthatasweaddmoreunitsofavariableinput tofixedamountsoflandandcapital,thechangeintotaloutputwillatfirstriseandthenfall. Diminishingreturnstolabouroccurswhenmarginalproductoflabourstartstofall.Thismeansthat totaloutputwillbeincreasingatadecreasingrate. Whathappenstomarginalproductislinkeddirectlytotheproductivityofeachextraworker.Beyond acertainpointnewworkerswillnothaveasmuchcapitaltoworkwithsoitbecomesdiluted amongalargerworkforce.Asaresult,themarginalproductivitytendstofallthisistheprincipleof diminishingreturns.Anexampleisshownbelow.Weassumethatthereisafixedsupplyofcapital (20units)availableintheproductionprocesstowhichextraunitsoflabourareadded. Initiallythemarginalproductisrisinge.g.the4thworkeradds26tooutputandthe5thworker adds28. Itpeakswhenthesixthworkedisemployedwhenthemarginalproductis29. Marginalproductthenstartstofall.Atthispointproductiondemonstratesdiminishingreturns. TheLawofDiminishingReturns CapitalInput 20 20 20 20 20 20 20 20 20 20 LabourInput 1 2 3 4 5 6 7 8 9 10 TotalOutput MarginalProduct AverageProductofLabour 5 16 30 56 85 114 140 160 171 180 11 14 26 28 29 26 20 11 9 5 8 10 14 17 19 20 20 19 18
Total Output (Q)
Slopeofthecurvegivesthe marginalproductoflabour
(Q)
Diminishingreturnsareapparent heretotaloutputisrisingbutata decreasingrate
Averageproductrisesaslongasthemarginalproductisgreaterthantheaverageforexample whentheseventhworkerisaddedthemarginalgaininoutputis26andthisdragstheaverageup from19to20units.Oncemarginalproductisbelowtheaverageasitiswiththeninthworker employed(wheremarginalproductisonly11)thentheaveragemustdecline. Thisisanimportantexampleoftherelationshipbetweenmarginalandaveragevaluesthatwewill returntolateronwhenstudyingcostsandrevenues. CriticismsoftheLawofDiminishingReturns Howrealisticisthisassumptionofdiminishingreturns?Surelyambitiousandsuccessfulbusinesses willdotheirlevelbesttoavoidsuchaproblememerging? Itisnowwidelyrecognisedthattheeffectsofglobalisationandtheabilityoftransnational corporationstosourcetheirinputsfrommorethanonecountryandengageintransfersof businesstechnology,makesdiminishingreturnslessrelevant.Manybusinessesaremultiplant meaningthattheyoperatefactoriesindifferentlocationscanswitchoutputtomeetchanging demand. Ariseinproductivityandtheproductionfunction Inthefollowingdiagramwetracetheeffectsofariseintheproductivityofthelabourforceateach levelofemployment. Ifaverageproductivityrises,thentheproductioncurveshiftsupwards. Diminishingreturnsarestillassumedtoexistinthisdiagramasshownbytheshapeofthe productioncurve,buttotaloutputishigherforeachnumberofpeopleemployed. Ifproductivityrises,foragivenlevelofwages,thiswillcauseafallintheunitlabourcostsof production. Otherthingsremainingthesame,thereisaninverserelationshipbetweenproductivityandcost. Thisisanimportantrelationshipforbusinessestounderstandwhentheyareseekingefficiencygains asameansofboostingprofits. LongRunProductionReturnstoScale Inthelongrun,allfactorsofproductionarevariable.Howtheoutputofabusinessrespondstoa changeinfactorinputsiscalledreturnstoscale. Numericalexampleoflongrunreturnstoscale
UnitsofLabourEmployed(L)
Unitsof Capital 20 40 60 80 100
Unitsof Labour 150 300 450 600 750
Total Output 3000 7500 12000 16000 18000
%Changein Inputs 100 50 33 25
%Changein Output 150 60 33 13
ReturnstoScale Increasing Increasing Constant Decreasing
Inourexamplewhenwedoublethefactorinputsfrom(150L+20K)to(300L+40K)thenthe percentagechangeinoutputis150%thereareincreasingreturnstoscale. Incontrast,whenthescaleofproductionischangedfrom(600L+80K0to(750L+100K) thenthepercentagechangeinoutput(13%)islessthanthechangeininputs(25%)implying asituationofdecreasingreturnstoscale. Increasingreturnstoscaleoccurwhenthe%changeinoutput>%changeininputs Decreasingreturnstoscaleoccurwhenthe%changeinoutput<%changeininputs Constantreturnstoscaleoccurwhenthe%changeinoutput=%changeininputs Thenatureofthereturnstoscaleaffectstheshapeofabusinessslongrunaveragecostcurve.
2. Howcanwecalculatethecostsofafirm?
Inthischapterwelookatproductioncosts.Intheshortrun,becauseatleastonefactorof productionisfixed,outputcanbeincreasedonlybyaddingmorevariablefactors. Fixedcosts Fixedcostsdonotvarydirectlywiththelevelofoutput Examplesoffixedcostsincludetherentalcostsofbuildingsthecostsofleasingorpurchasing capitalequipmentsuchasplantandmachinerytheannualbusinessratechargedbylocal authoritiesthecostsoffulltimecontractedsalariedstaffthecostsofmeetinginterestpaymentson loansthedepreciationoffixedcapital(duesolelytoage)andalsothecostsofbusinessinsurance. Fixedcostsaretheoverheadcostsofabusiness. Keypoints:
Totalfixedcosts
(TFC)
theseremainconstantasoutputincreases totalfixedcostsdividedbyoutput
Averagefixedcost (AFC)=
Averagefixedcostsmustfallcontinuouslyasoutputincreasesbecausetotalfixedcostsare beingspreadoverahigherlevelofproduction.Inindustrieswheretheratiooffixedtovariablecosts isextremelyhigh,thereisgreatscopeforabusinesstoexploitlowerfixedcostsperunitifitcan produceatabigenoughsize.ConsidertheSonyPS3orthenewiPhonewherethefixedcostsof developingtheproductareenormous,butthesecostscanbedividedbymillionsofindividualunits soldacrosstheworld.Successfulproductlaunchesandhugevolumesalescanmakeahuge differencetotheaveragetotalcostsofproduction. Pleasenote!Achangeinfixedcostshasnoeffectonmarginalcosts.Marginalcostsrelateonlyto variablecosts! VariableCosts Variablecostsarecoststhatvarydirectlywithoutput. Examplesofvariablecostsincludethecostsofrawmaterialsandcomponents,thewagesofpart timestafforemployeespaidbythehour,thecostsofelectricityandgasandthedepreciationof capitalinputsduetowearandtear.Averagevariablecost(AVC)=totalvariablecosts(TVC)/output (Q) AverageTotalCost(ATCorAC) Averagetotalcostisthecostperunitproduced Averagetotalcost(ATC)=totalcost(TC)/output(Q) MarginalCost Marginalcostisthechangeintotalcostsfromincreasingoutputbyoneextraunit. Themarginalcostofsupplyinganextraunitofoutputislinkedwiththemarginalproductivityof labour.Thelawofdiminishingreturnsimpliesthatmarginalcostwillriseasoutputincreases. Eventually,risingmarginalcostwillleadtoariseinaveragetotalcost.Thishappenswhentherisein AVCisgreaterthanthefallinAFCasoutput(Q)increases. Anumericalexampleofshortruncostsisshowninthetablebelow.Fixedcostsareassumedtobe constantat200.Variablecostsincreaseasmoreoutputisproduced.
Output TotalFixed (Q) Costs(TFC)
TotalVariable Costs(TVC)
TotalCost
AverageCost PerUnit
MarginalCost (thechangeintotal costfromaoneunit changeinoutput)
(TC=TFC+ TVC) 0 50 100 150 200 250 300 350 400 450 500 200 200 200 200 200 200 200 200 200 200 200 0 100 180 230 260 280 290 325 400 610 750 200 300 400 450 460 465 480 525 600 810 1050
(AC=TC/Q) 6 4 3 2.3 1.86 1.6 1.5 1.5 1.8 2.1 2 2 1 0.2 0.1 0.3 0.9 1.5 4.2 4.8
Inourexample,averagecostperunitisminimisedatarangeofoutput350and400units. Thereafter,becausethemarginalcostofproductionexceedsthepreviousaverage,sothe averagecostrises(forexamplethemarginalcostofeachextraunitbetween450and500is 4.8andthisincreaseinoutputhastheeffectofraisingthecostperunitfrom1.8to2.1). Anexampleoffixedandvariablecostsinequationformat Ifforexample,theshortruntotalcostsofafirmaregivenbytheformula SRTC=$(10000+5X2)whereXisthelevelofoutput. Thefirmstotalfixedcostsare$10,000 Thefirmsaveragefixedcostsare$10,000/X Ifthelevelofoutputproducedis50units,totalcostswillbe$10,000+$2,500=$12,500 TheShapeofShortRunCostCurves Whendiminishingreturnssetin(beyondoutputQ1)themarginalcostcurvestartstorise.Average totalcostcontinuestofalluntiloutputQ2wheretheriseinaveragevariablecostequateswiththefall inaveragefixedcost.OutputQ2isthelowestpointoftheATCcurveforthisbusinessintheshort run.Thisisknownastheoutputofproductiveefficiency.
10
Ifmarginalcostisbelowaveragecostthenaveragemustbefalling.EvenifMCisrising,ACfalls ifMC<AC.Forthisreason,MCcurveintersectstheACcurveatthelowestpointoftheAC curve.Diminishingreturnsstartstooccurwhenmarginalcoststartstorise. Costs MarginalCost (MC) AverageTotal Cost(ATC)
Average VariableCost (AVC)
AverageFixed Cost(AFC) Q1 Q2 Output(Q)
Keypoint:Themarginalcostcurvemustintersecttheaveragecurvesattheirminimumlevels Achangeinvariablecosts Ariseinthevariablecostsofproductionperhapsduetoariseinoilandgaspricesorariseinthe nationalminimumwageleadstoanupwardshiftbothinmarginalandaveragetotalcost.Thefirmis notabletosupplyasmuchoutputatthesameprice.Theeffectisthatofaninwardshiftinthesupply curveofabusinessinacompetitivemarket.
11
Costs
MC2
MarginalCost (MC1)
AC2 AverageTotal Cost(ATC1)
AVC2
Average VariableCost (AVC1)
Output(Q)
Anincreaseinfixedcostshasnoeffectonthevariablecostsofproduction.Thismeansthatonlythe averagetotalcostcurveshifts.Thereisnochangeonthemarginalcostcurveleadingtonochange intheprofitmaximisingpriceandoutputofabusiness.Theeffectsofanincreaseinthefixedor overheadcostsofabusinessareshowninthediagrambelow.

Costs MC AC2(afterrise infixedcosts)
AC1
Output(Q)
Suggestionsforbackgroundreadingonchangesinbusinesscosts Cadburysplanstoincreaseprices(BBCnews,February2008) Drycleanersfacingrisingcosts(BBCnews,June2008) Grainpricesaresqueezingbakers(BBCnews,April2008)

12
MilkcostshitStiltonproducers(BBCnews,July2007)
13
3. LongRunCosts:EconomiesandDiseconomiesofScale
EconomiesofScale Economiesofscalearethecostadvantagesfromexpandingthescaleofproductionin thelongrun.Theeffectistoreduceaveragecostsoverarangeofoutput. Theselowercostsrepresentanimprovementinproductiveefficiencyandcanalsogivea businessacompetitiveadvantageinthemarketplace.Theyleadtolowerpricesandhigher profitsapositivesumgameforproducersandconsumers. Wemakenodistinctionbetweenfixedandvariablecostsinthelongrunbecauseallfactors ofproductioncanbevaried.Aslongasthelongrunaveragetotalcost(LRAC)isdeclining, economiesofscalearebeingexploited. LongRunOutput(Units) 1000 2000 5000 10000 20000 50000 100000 500000 Returnstoscaleandcostsinthelongrun Thetablebelowshowshowchangesinthescaleofproductioncan,ifincreasingreturnstoscale areexploited,leadtolowerlongrunaveragecosts. ScaleA ScaleB ScaleC FactorInputs (K) Capital 5 10 15 (La) Land 3 6 9 (L) Labour 4 8 12 Production (Q) Output 100 300 500 Costs (TC) TotalCost 3256 6512 9768 (TC/Q) Average Cost 32.6 21.7 19.5 TotalCosts(s) 12000 20000 45000 80000 144000 330000 640000 3000000 LongRunAverageCost(perunit) 12 10 9 8 7.2 6.6 6.4 6
Costs:Assumethecostofeachunitofcapital=600,Land=80andLabour=200 Becausethe%changeinoutputexceedsthe%changeinfactorinputsused,then,althoughtotal costsrise,theaveragecostperunitfallsasthebusinessexpandsfromscaleAtoBtoC.

14
IncreasingReturnstoScale Muchofthenewthinkingineconomicsfocusesontheincreasingreturnsavailabletoacompany growinginsizeinthelongrun. Anexampleofthisisthecomputersoftwarebusiness.Theoverheadcostsofdevelopingnew softwareprogramssuchasMicrosoftVistaorcomputergamessuchasHalo3arehugeoften runningintohundredsofmillionsofdollarsbutthemarginalcostofproducingoneextracopyfor saleisclosetozero,perhapsjustafewcentsorpennies.Ifacompanycanestablishitselfinthe marketinprovidingapieceofsoftware,positivefeedbackfromconsumerswillexpandtheinstalled customerbase,raisedemandandencouragethefirmtoincreaseproduction.Becausethemarginal costissolow,theextraoutputreducesaveragecostscreatingeconomiesofsize. Lowercostsnormallymeanhigherprofitsandincreasingfinancialreturnsfortheshareholders.What istrueforsoftwaredevelopersisalsoimportantfortelecomscompanies,transportoperatorsand musicdistributors.Wefindacrosssomanydifferentmarketsthatahighpercentageofcostsarefixed thehigherisdemandandoutput,thelowerwillbetheaveragecostofproduction. LongRunAverageCostCurve TheLRACcurve(alsoknownastheenvelopecurve)isusuallydrawnontheassumptionoftheir beinganinfinitenumberofplantsizeshenceitssmoothappearanceinthenextdiagrambelow. ThepointsoftangencybetweenLRACandSRACcurvesdonotoccurattheminimumpointsofthe SRACcurvesexceptatthepointwheretheminimumefficientscale(MES)isachieved. IfLRACisfallingwhenoutputisincreasingthenthefirmisexperiencingeconomiesofscale.For exampleadoublingoffactorinputsmightleadtoamorethandoublingofoutput. Conversely,WhenLRACeventuallystartstorise,thefirmexperiencesdiseconomiesofscale,and, IfLRACisconstant,thenthefirmisexperiencingconstantreturnstoscale
Costs
SRAC1
SRAC2
SRAC3
AC1
LRAC
AC2 AC3
Q1
Q2
Q3
Output(Q)
15
Therearemanydifferenttypesofeconomyofscale.Dependingonthecharacteristicsofanindustry ormarket,somearemoreimportantthanothers. Internaleconomiesofscale(IEoS) Internaleconomiesofscalecomefromthelongtermgrowthofthefirmitself.Examplesinclude: 1. Technicaleconomiesofscale:(theserelatetoaspectsoftheproductionprocessitself): a. Expensivecapitalinputs:Largescalebusinessescanaffordtoinvestinspecialist capitalmachinery.Forexample,asupermarketmightinvestindatabasetechnology thatimprovesstockcontrolandreducestransportationanddistributioncosts.Highly expensivefixedunitsofcapitalarecommoninnearlyeverymassmanufacturing productionprocess. b. Specializationoftheworkforce:Largerfirmscansplittheproductionprocessesinto separatetaskstoboostproductivity.Examplesincludetheuseofdivisionoflabour inthemassproductionofmotorvehiclesandinmanufacturingelectronicproducts. c. Thelawofincreaseddimensions(orthecontainerprinciple)Thisislinkedtothe cubiclawwheredoublingtheheightandwidthofatankerorbuildingleadstoamore thanproportionateincreaseinthecubiccapacitytheapplicationofthislawopensup thepossibilityofscaleeconomiesindistributionandfreightindustriesandalsoin travelandleisuresectorswiththeemergenceofsupercruiserssuchasP&Os Ventura.Considerthenewgenerationofsupertankersandthedevelopmentof enormouspassengeraircraftsuchastheAirbus280whichiscapableofcarryingwell over500passengersonlonghaulflights.Thelawofincreaseddimensionsisalso importantintheenergysectorsandinindustriessuchasofficerentaland warehousing.AmazonUKforexamplehasinvestedinseveralhugewarehousesatits centraldistributionpointscapableofstoringhundredsofthousandsofitems. d. Learningbydoing:Thereisgrowingevidencethatindustrieslearnbydoing!The averagecostsofproductiondeclineinrealtermsasaresultofproductionexperience asbusinessescutwasteandfindthemostproductivemeansofproducingoutputona biggerscale.Evidenceacrossawiderangeofindustriesintosocalledprogress ratios,orexperiencecurvesorlearningcurveeffects,indicatethatunit manufacturingcoststypicallyfallbybetween70%and90%witheachdoublingof cumulativeoutput.Businessesthatexpandtheirscalecanachievesignificant learningeconomiesofscale.
16
Cost (Perunitofoutput)
EconomiesofScale A B LRAC1 Learning economies C
LRAC2
Output
2. Monopsonypower:Alargefirmcanpurchaseitsfactorinputsinbulkatdiscountedprices ifithasmonopsony(buying)power.Agoodexamplewouldbetheabilityoftheelectricity generatorstonegotiatelowerpriceswhenfinalizingcoalandgassupplycontracts.The nationalfoodretailershavemonopsonypowerwhenpurchasingtheirsuppliesfromfarmers andwinegrowersandincompletingsupplycontractsfromfoodprocessingbusinesses.Other controversialexamplesoftheuseofmonopsonypowerincludethepricespaidbycoffee roastersandothermiddlementocoffeeproducersinsomeofthepoorestpartsoftheworld. 3. Managerialeconomiesofscale:Thisisaformofdivisionoflabourwherefirmscan employspecialiststosuperviseproductionsystems.Bettermanagementincreased investmentinhumanresourcesandtheuseofspecialistequipment,suchasnetworked computerscanimprovecommunication,raiseproductivityandtherebyreduceunitcosts. 4. Financialeconomiesofscale:Largerfirmsareusuallyratedbythefinancialmarketstobe morecreditworthyandhaveaccesstocreditwithfavourableratesofborrowing.In contrast,smallerfirmsoftenpayhigherratesofinterestonoverdraftsandloans.Businesses quotedonthestockmarketcannormallyraisenewfinancialcapitalmorecheaplythroughthe saleofequitiestothecapitalmarket. 5. Networkeconomiesofscale:(Pleasenote:Thistypeofeconomyofscaleislinkedmoreto thegrowthofdemandforaproductbutitisstillworthunderstandingandapplying.)Thereis growinginterestintheconceptofanetworkeconomy.Somenetworksandserviceshave hugepotentialforeconomiesofscale.Thatis,astheyaremorewidelyused(oradopted), theybecomemorevaluabletothebusinessthatprovidesthem.Wecanidentifynetworks economiesinareassuchasonlineauctionsandairtransportnetworks.Themarginal costofaddingonemoreusertothenetworkisclosetozero,buttheresultingfinancial benefitsmaybehugebecauseeachnewusertothenetworkcantheninteract,tradewithall oftheexistingmembersorpartsofthenetwork.Therapidexpansionofecommerceisa greatexampleoftheexploitationofnetworkeconomiesofscale.EBayisaclassicexampleof exploitingnetworkeconomiesofscaleaspartofitsoperations.
17
Thecontainerprincipleatwork! Economiesofscaletheeffectsonprice,outputandprofitsforaprofitmaximizingfirm ScaleeconomiesallowasuppliertomovefromSRAC1toSRAC2.Aprofitmaximisingproducerwill produceatahigheroutput(Q2)andchargealowerprice(P2)asaresultbutthetotalabnormal profitisalsomuchhigher(comparethetwoshadedregions). Bothconsumerandproducersurplus(welfare)hasincreasedtherehasbeenanimprovementin economicwelfareandeconomicefficiencythekeyiswhethercostsavingsarepassedonto consumers!

Costs MC1 ProfitatPriceP1 SRAC1 ProfitatPriceP2
P1
SRAC2 P2 MC2
AR (Demand) MR Q1 Q2
Output(Q)
Externaleconomiesofscale(EEoS) Externaleconomiesofscaleoccuroutsideofafirmbutwithinanindustry.Forexample investmentinabettertransportationnetworkservicinganindustrywillresultinginadecreasein

18
costsforacompanyworkingwithinthatindustry,thusexternaleconomiesofscalehavebeen achieved.Anotherexampleisthedevelopmentofresearchanddevelopmentfacilitiesinlocal universitiesthatseveralbusinessesinanareacanbenefitfrom.Likewise,therelocationof componentsuppliersandothersupportbusinessesclosetothecentreofmanufacturingarealso anexternalcostsaving. Agglomerationeconomiesmayalsoresultresultingfromtheclusteringofsimilarbusinessesina distinctgeographicallocationbeitsoftwarebusinessesinSiliconValleyorinvestmentbanksinthe CityofLondon. EconomiesofScaleTheImportanceofMarketDemand Themarketstructureofanindustryisaffectedbytheextentofeconomiesofscaleavailableto individualsuppliersandbythetotalsizeofmarketdemand.Inmanyindustries,itispossiblefor smallerfirmstomakeaprofitbecausethecostdisadvantagestheyfacearerelativelysmall.Or becauseproductdifferentiationallowsabusinesstochargeapricepremiumtoconsumerswhich morethancoverstheirhighercosts. Agoodexampleistheretailmarketforfurniture.Theindustryhassomemajorplayersineachofits differentsegments(e.g.flatpackanddesignerfurniture)includingtheSwedishgiantIKEA.However, muchofthemarketistakenbysmallerscalesupplierswithconsumerswillingtopayhigherpricesfor bespokefurnitureowingtothelowpriceelasticityofdemandforhighquality,handcraftedfurniture products.Smallscalemanufacturerscanthereforeextracttheconsumersurplusthatispresent whendemandisestimatedtohavealowelasticityofdemand. EconomiesofScope Thesearedifferentfromeconomiesofscale!Economiesofscopeoccurwhereitischeaperto producearangeofproductsratherthanspecializeinjustahandfulofproducts.Andtheycanbe exploitedwhenabusinessownsaresourcethatcanbeusedmorethanonceindifferentways! Forexample,intheincreasinglycompetitiveworldofpostalservicesandbusinesslogistics,themain serviceproviderssuchasRoyalMail,UKMail,DeutschePostandtheinternationalparcelcarriers includingTNT,UPS,andFedExarebroadeningtherangeoftheirservicesandmakingmorebetter useoftheirexistingcollection,sortinganddistributionnetworkstoreducecostsandearnhigher profitsfromhigherprofitmarginandfastgrowingmarkets. Acompanysmanagementstructure,administrationsystemsandmarketingdepartmentsare capableofcarryingoutthesefunctionsformorethanoneproduct. Expandingtheproductrangetoexploitthevalueofexistingbrandsisagoodwayofexploiting economiesofscope.PerhapsagoodexampleofbrandextensionistheEasyGroupunderthe controlofStelioswherethedistinctiveEasyGroupbusinessmodelhasbeenapplied(withvarying degreesofsuccess)toawiderangeofmarketseasyPizza,easyCinema,easyCarrental,easy BusandeasyHoteltonamejustahandful!ProcterandGambleisthelargestconsumerhousehold productsmakerintheworld.ItsbrandsincludeCrest,Duracell,Gillette,Pantene,andTide,toname justafew.Twentyfourofitsbrandsmakeover$1billioninsalesannually. Anotherexampleofaneconomyofscopemightbearestaurantthathascateringfacilitiesanduses itformultipleoccasionsasacoffeeshopduringthedayandasasupperbarandjazzroominthe evenings.Oracomputingbusinesscanuseitsnetworkanddatabasesformanydifferentuses. CaseStudy:InvestmentinSportsGrounds Hotelsareahottopicatsportsvenues.Theownersofthesevenuesarelookingforwaystomake betterreturnontheirassets.Thesolutionistoexplorenewbusinessopportunities,investin extensivemodernisationandspendcashonlargescaleredevelopmentschemes.
19
Capacityutilisationisanimportantchallengefacingasportingvenue.Thereareonlysomany cricketmatches,grandprixracesorrugbygamesthatdrawspectators. Byaddingpurposebuiltconference,banquetingandleisurefacilities,sportsvenuescantapintoa differentcustomerbase.Ahotelfacilitycanattractdemandfrombusinesseslookingforcorporate hospitalityandconferences.Havingahotelalsoallowsavenuetoaccessconsumerspendingon shortbreaksoneofthefastestgrowingsegmentsoftheleisureindustry.Mostoftheplanned hotelswillbebranded(e.g.HolidayInn,Marriott)whichallowsthevenuetobenefitfromatrusted hotelnameandgetsaccesstoestablisheddistributionchannels. Source:BusinessCafe MinimumEfficientScale(MES) Theminimumefficientscale(MES)isthescaleofproductionwheretheinternaleconomiesof scalehavebeenfullyexploited.TheMEScorrespondstothelowestpointonthelongrun averagecostcurveandisalsoknownasanoutputrangeoverwhichabusinessachieves productiveefficiency. TheMESisnotasingleoutputlevelmorelikelywedescribetheminimumefficientscaleas comprisingarangeofoutputswherethefirmachievesconstantreturnstoscaleandhasreached thelowestfeasiblecostperunit.
Costs Revenues
LRAC
Increasingreturntoscaleeconomiesof scalefallingLRAC
Decreasingreturns diseconomiesofscale
MES
Q2
Output(Q)
TheMESdependsonthenatureofcostsofproductioninaspecificsectororindustry. 1. Inindustrieswheretheratiooffixedtovariablecostsishigh,thereisplentyofscopefor reducingunitcostbyincreasingthescaleofoutput.Thisislikelytoresultinaconcentrated marketstructure(e.g.anoligopoly,aduopolyoramonopoly)indeedeconomiesofscale mayactasabarriertoentrybecauseexistingfirmshaveachievedcostadvantagesand theythencanforcepricesdownintheeventofnewbusinessescomingin! 2. Incontrast,theremightbeonlylimitedopportunitiesforscaleeconomiessuchthattheMES turnsouttobeasmall%ofmarketdemand.Itislikelythatthemarketwillbecompetitive withmanysuppliersabletoachievetheMES.Anexamplemightbealargenumberofhotels inacitycentreoraclusterofrestaurantsinatown.Muchdependsonhowwedefinethe market!
20
3. Withanaturalmonopoly,thelongrunaveragecostcurvecontinuestofalloverahuge rangeofoutput,suggestingthattheremayberoomforperhapsoneortwosupplierstofully exploitalloftheavailableeconomiesofscalewhenmeetingmarketdemand. Diseconomiesofscale Diseconomiesaretheresultofdecreasingreturnstoscale. Thepotentialdiseconomiesofscaleafirmmayexperiencerelateto: 1. Controlmonitoringtheproductivityandthequalityofoutputfromthousandsofemployees inbigcorporationsisimperfectandcostlythislinkstotheconceptoftheprincipalagent problemhowbestcanmanagersassesstheperformanceoftheirworkforcewheneachof thestakeholdersmayhaveadifferentobjectiveormotivationwhichcanleadtostakeholder conflict? 2. Coordinationitcanbedifficulttocoordinatecomplicatedproductionprocessesacross severalplantsindifferentlocationsandcountries.Achievingefficientflowsofinformationin largebusinessesisexpensiveasisthecostofmanagingsupplycontractswithhundredsof suppliersatdifferentpointsofanindustryssupplychain. 3. Cooperationworkersinlargefirmsmaydevelopasenseofalienationandlossofmorale. Iftheydonotconsiderthemselvestobeanintegralpartofthebusiness,theirproductivity mayfallleadingtowastageoffactorinputsandhighercosts.Traditionallythishasbeenseen asaproblemexperiencedbythelargerstatesectorbusinesses,examplesbeingtheRoyal MailandtheFirefighters,theresultbeingapoorandcostlyindustrialrelationsperformance. However,theproblemisnotconcentratedsolelyinsuchindustries.Agoodrecentexampleof abitterindustrialrelationsdisputewasbetweenGateGourmetanditsworkers. Avoidingdiseconomiesofscale Anumberofeconomistsareskepticalaboutdiseconomiesofscale.Theybelievethatproper managementtechniquesandappropriateincentivescandomuchtoreducetheriskofindustrial strife.Herearethreeofthereasonstodoubtthepersistenceofdiseconomiesofscale: 1. Developmentsinhumanresourcemanagement(HRM).HRMisahorriblephraseto describeimprovementsthatabusinessmightmaketoproceduresinvolvingworker recruitment,training,promotion,retentionandsupportoffacultyandstaff.Thisbecomes criticaltoabusinesswhentheskilledworkersitneedsareinshortsupply.Recruitmentand retentionofthemostproductiveandeffectiveemployeesmakesasizeabledifferenceto corporateperformanceinthelongrun. 2. Performancerelatedpayschemes(PRP)canprovidefinancialincentivesfortheworkforce leadingtoanimprovementinindustrialrelationsandhigherproductivity.AnotheraimofPRP isforbusinessestorewardandhangontotheirmostefficientworkers.TheJohnLewis Partnershipisoftencitedasanexampleofhowabusinesscanempoweritsemployeesby givingthemastakeinthefinancialsuccessoftheorganization. 3. Increasinglycompaniesareengaginginoutsourcingofmanufacturinganddistributionas theyseektosupplytoeverdistantmarkets.Outsourcingisatriedandtestedwayofreducing costswhilstretainingcontroloverproductionalthoughtheremaybeapricetopayintermsof theimpactonthejobsecurityofworkerswhosefunctionsmightbeoutsourcedoverseas. CaseStudy:AmazonEconomiesofScaleandScope
21
Increaseddimensions:Firstly,thecompanyinvestedinenormouswarehousestostockitsinventory ofbooks,DVDs,computerperipherals.Thisallowsittobenefitfromthelawofincreaseddimension. Buyingpower:Amazonhassignificantmonopsonypowerwhenitpurchasesbooksdirectlyfrom publishers,therebybypassingitsrelianceonwholesalersandgivingitahigherprofitmargin. Learningbydoingandfirstmoveradvantage:Amazonisbenefitingfromlearningbydoinghaving beenoneofthefirstmajorplayersintheonlineretailsector.Theunitcostsofproductiontendto declineinrealtermsasaresultofproductionexperienceasbusinessescutwasteandfindthemost productivemeansofproducingoutputonabiggerscale PreOrdersAmazonuseapreordersystemforcustomerswhichallowsittocaptureearlydemand andimprovestock(orinventory)forecasting. Lessinvestedcapital:Asanonlineretailer,Amazonavoidstheneedforretailstoresone advantageisthatithaslowerinvestedcapitalinthebusinessanditfreesupresourcesforcustomer fulfillmentandinvestmentinnewtechnologyAmazondistributestoover200countries. Shiftingstockatspeed:Amazonhasamuchfasterstockvelocitymeasuredbythenumberof weeksanitemremainsinstock.ForAmazonthisishalfthatofaphysicalstoreandthebenefitisa reductioninobsolescenceloss(thevalueofunsoldstockisestimatedtodeclineby30%peryear) EconomiesofscalehelptogiveAmazonasignificantcostadvantage.Thebusinessisalsolooking tocreateeconomiesofscopefrommarketingandbroadeningtherangeofproductsavailable throughtheAmazonbrand.Amongtheinnovativebusinessideasunderdevelopmentwecan identify: Merchants@/Marketplacewhichgivesindependent(thirdparty)sellerstheopportunitytosell theirproductsthroughtheAmazonplatform AmazonEnterpriseSolutionswhereAmazonprovidesecommercetechnologyforarange ofpartnerssuchasMarksandSpencer,Lacoste,MothercareandTimex CreateSpaceanewselfpublishingplatformforbooks,musicandvideo AmazonKindleaportablereaderthatwirelesslydownloadsbooks,blogs,magazinesand newspaperstoahighresolutionelectronicpaperdisplaythatlooksandreadslikerealpaper, AmazonnowsellsnearlyonefifthofthebooksboughtintheUKeachyear. Suggestionsforfurtherreadingoneconomiesofscaleandscope
22
Consoleslooktohittheirstride(BBCnews,July2008) Costheadacheforgamesdevelopers(BBCnews,December2007) Economiesofscaleinprinting(Tutor2ueconomicsblog,March2008) GMinstallsworld'sbiggestrooftopsolarpanels(Guardian,July2008) Howworld'sbiggestshipisdeliveringourChristmasallthewayfromChina(Guardian) Mobilewebreachescriticalmass(BBCnews,July2008) Saladproductiononamassivescale(BBCnews,June2008)
23
4. BusinessRevenues
Revenue(orturnover)istheincomegeneratedfromthesaleofoutputinproductmarkets. o AverageRevenue(AR)=Priceperunit=totalrevenue/output o MarginalRevenue(MR)=thechangeinrevenuefromsellingoneextraunitofoutput Thetablebelowshowsthedemandforaproductwherethereisadownwardslopingdemandcurve. Priceperunit (averagerevenue) s 400 370 340 310 280 250 220 190 AverageandMarginalRevenue Inourexampleinthetableabove,aspriceperunitfalls,demandexpandsandtotalrevenuerises althoughbecauseaveragerevenuefallsasmoreunitsaresold,thiscausesmarginalrevenueto decline.Eventuallymarginalrevenuebecomesnegative,afurtherfallinprice(e.g.from220to 190)causestotalrevenuetofall. Becausethepriceperunitisdeclining,totalrevenueisrisingatadecreasingrateandwilleventually reachamaximum(seethenextparagraph). ElasticityofDemandandTotalRevenue Whenafirmfacesaperfectlyelasticdemandcurve,thenaveragerevenue=marginalrevenue(i.e. extraunitsofoutputcanallbesoldattherulingmarketprice). However,mostbusinessesfaceadownwardslopingdemandcurve!Andbecausethepriceperunit mustbecuttosellextraunits,thereforeMRliesbelowAR.InfactheMRcurvewillfallattwicethe rateoftheARcurve.Youdonthavetoprovethisfortheexamsbutitisworthrememberingthat themarginalrevenuecurvehastwicetheslopeoftheARcurve! Maximumtotalrevenueoccurswheremarginalrevenueiszero:nomorerevenuecanbeachieved fromproducinganextraunitofoutput.Thispointisdirectlyunderneaththemidpointofalinear demandcurve. QuantityDemanded (Qd) units 220 340 460 580 700 820 940 1060 TotalRevenue (TR)(PxQ) s 88000 125800 156400 179800 196000 205000 206800 201400 MarginalRevenue (MR) s 315 255 195 135 75 15 45
24
Revenue
Totalrevenueis maximisedwhen MR=0
TotalRevenue (TR)
Ped>1foraprice fallalongthis lengthofAR
Priceelasticityof demand=1atthis output
MarginalRevenue (MR)
AverageRevenue (Demand)AR
Output(Q)
Totalrevenueisshownbytheareaunderneaththefirmsdemandcurve(averagerevenuecurve).
Totalrevenue(TR)referstotheamountofmoneyreceivedbyafirmfromsellingagiven levelofoutputandisfoundbymultiplyingprice(P)byoutputienumberofunitssold
Costs
P2
TotalrevenueatpriceP1wheremarginal revenueiszero
P1
AriseinpricetoP2causesareductionintotal revenue
AveragerevenueAR
TotalrevenueatpriceP2
Q2
Q1
MarginalrevenueMR
Output(Q)
Suggestionsforfurtherreadingonbusinessrevenues Carmakerstackleprofitproblems(BBCnews,July2008)
25
RevenuefearshitVodafoneshares(BBCnews,July2008) Priceelasticityofdemandandtotalrevenue(BrynJonesOnline,YouTubevideo)
26
5. Profits
TheNatureofProfit Profitmeasuresthereturntoriskwhencommittingscarceresourcestoamarketorindustry. Entrepreneurstakerisksforwhichtheyrequireanadequateexpectedrateofreturn.Thehigher themarketriskandthelongertheyexpecttohavetowaittoearnapositivereturn,thegreaterwillbe theminimumrequiredreturnthatanentrepreneurislikelytodemand. 1. Normalprofitistheminimumlevelofprofitrequiredtokeepfactorsofproductionintheir currentuseinthelongrun.Normalprofitsreflecttheopportunitycostofusingfundsto financeabusiness.Ifyoudecidetoput200,000ofyourpersonalsavingsintoanewbusiness, thosefundscouldhaveearnedalowriskrateofreturnbybeingsavedinabankorbuilding societydepositaccount.Youmightthereforeusetherateofinterestonthat200,000asthe minimumrateofreturnthatyouneedtomakefromyourinvestmentinordertokeepgoinginthe longrun! Ofcourseweareignoringheredifferencesinriskandalsothenonfinancialbenefitsofrunningand buildingyourownbusinessorinvestingfundsinsomeoneelsesproject. Becausewetreatnormalprofitasanopportunitycostofinvestingfinancialcapitalinabusiness, wenormallyincludeanestimatefornormalprofitintheaveragetotalcostcurve,thus,ifthefirm coversitsATC(whereARmeetsAC)thenitismakingnormalprofits. 2. Subnormalprofitisanyprofitlessthannormalprofit(whereprice<averagetotalcost) 3. Abnormalprofitisanyprofitachievedinexcessofnormalprofitalsoknownas supernormalprofit.Afirmearnssupernormalprofitwhenitsprofitisabovethatrequiredtokeep itsresourcesintheirpresentuseinthelongrun.Whenfirmsaremakingabnormalprofits,thereis anincentiveforotherproducerstoenteramarkettotrytoacquiresomeofthisprofit.Abnormal profitpersistsinthelongruninimperfectlycompetitivemarketssuchasoligopolyand monopolywherefirmscansuccessfullyblocktheentryofnewfirms.Wewillcometothislater whenweconsiderbarrierstoentryinmonopoly. CaseStudy:Subnormalprofitsdrivemortgagelendersoutofthemarketfornow WhatishappeningintheUKmortgagemarket?Rarelyadaygoesbywithoutnewsofanother mortgagelenderreassessingtheriskoftheirhousingloansanddecidingtopulltheplugonsomeof theirmortgageproducts.FollowingonfromtheNorthernRockwhichhasvirtuallystoppedlendingat allandwantstoshiftasizeableportionofitsmortgagebookontoothers,theCooperativeBank, LehmanBrothersandFirstDirecthaveallannouncedthattheyarewithdrawingtwoyearfixedrate mortgageproductsforthetimebeing. Allofthisisoneofthedirectresultsofthecreditcrunch.Thelendersarespinningthisasawayof providingbetterservicelevelstotheirexistingcustomersbuttherealityisthatthesupplyoffinance inthewholesalemoneymarketshasbeenbadlysqueezedandthisisnowfeedingthroughtothe retailmarketforhousingloans.Itiscostingthemortgagelendersmoretoborrowfundsandtheir profitmarginshavebeensqueezedtoalevelwheresubnormalprofitsarebeingmade.Littlewonder thatsomeofthemajorplayersareeffectivelyexitingthemarketbywithdrawingsomemortgage productsfromsale.Onlywhenconditionsimprovewilltheyconsiderareturn. Source:Tutor2uEconomicsBlog,April2008 Calculatingeconomicprofit Considerthefollowingexample:
27
Thetableshowsdataforanownermanagedfirmforaparticularyear. Totalrevenue320,000 Rawmaterialcosts30,000 Wagesandsalaries85,000 Interestpaidonbankloan30,000 Salarythattheownercouldhaveearnedelsewhere32,000 Interestforgoneonowner'scapitalinvestedinthebusiness20,000 Inasimpleaccountingsense,thebusinesshastotalrevenueof320,000andcostsof145,000 givinganaccountingprofitof175,000.Butthefirmsprofitaccordingtoaneconomistshouldtake intoaccounttheopportunitycostofthecapitalinvestedinthebusinessandtheincomethatthe ownercouldhaveearnedelsewhere.Takingthesetwoitemsintoaccountwefindthattheeconomic profitis123,000. Profitmaximisation Profitsaremaximisedwhenmarginalrevenue=marginalcost PricePerUnit () 50 48 46 44 42 40 38 36 34 Demand/ Output (units) 33 39 45 51 57 63 69 75 81 Total Revenue () 1650 1872 2070 2244 2394 2520 2622 2700 2754 Marginal Revenue () 37 33 29 25 21 17 13 9 Total Cost () 2000 2120 2222 2312 2384 2444 2480 2534 2612 Marginal Cost () 20 17 15 12 10 6 9 13 Profit () 350 248 152 68 10 76 142 166 142
Considertheexampleinthetableabove.Aspriceperunit(averagerevenue)declines,sodemand expands.Totalrevenuerisesbutatadecreasingrate(asshownbycolumn4marginalrevenue). Initiallythefirmismakingalossbecausetotalcostexceedstotalrevenue.Thefirmmovesintoprofit atanoutputlevelof57units.Thereafterprofitisincreasingbecausethemarginalrevenuefrom sellingunitsisgreaterthanthemarginalcostofproducingthem.Considertheriseinoutputfrom69 to75units.TheMRis13perunit,whereasmarginalcostis9perunit.Profitsincreasefrom142 to166. Butoncemarginalcostisgreaterthanmarginalrevenue,totalprofitsarefalling.Indeedthe firmmakesalossifitincreasesoutputto93units.
28
Revenue AndCost MarginalCost
Profitsare increasingwhen MR>MC
Profitsare decreasingwhen MR<MC
Q1
MarginalRevenue
Output(Q)
Aslongasmarginalrevenueisgreaterthanmarginalcost,totalprofitswillbeincreasing(orlosses decreasing).Theprofitmaximisationoutputoccurswhenmarginalrevenue=marginalcost. Inthenextdiagramweintroduceaveragerevenueandaveragecostcurvesintothediagramsothat, havingfoundtheprofitmaximisingoutput(whereMR=MC),wecanthenfind(i)theprofitmaximising price(usingthedemandcurve)andthen(ii)thecostperunit. Thedifferencebetweenpriceandaveragecostmarkstheprofitmarginperunitofoutput. Totalprofitisshownbytheshadedareaandequalstheprofitmarginmultipliedbyoutput

Costs Revenue Supernormalprofitsat PriceP1andoutputQ1 NormalprofitatQ2where AR=AC
P1 SRMC
SRAC
AC1 AC2 AR (Demand)
Q1
MR
Q2
Output(Q)
Theshortrunsupplydecisiontheshutdownpoint Thetheoryofthefirmassumesthatabusinessneedstomakeatleastnormalprofitinthelongrunto justifyremaininginanindustrybutthisisnotastrictrequirementwhenthefirmwillcontinueto produceaslongastotalrevenuecoverstotalvariablecostsorputanotherway,solongaspriceper

29
unit>orequaltoaveragevariablecost(AR=AVC).Thisissometimesreferredtoastheshut downprice. Thereasonforthisisasfollows.Abusinesssfixedcostsmustbepaidregardlessofthelevelof output.Ifwemakeanassumptionthatthesecostsaresunkcosts(i.e.theycannotberecoveredif thefirmshutsdown)thenthelossperunitwouldbegreaterifthefirmweretoshutdown,provided variablecostsarecovered.

MC Costs, Revenues ATC
P1isbelowaveragevariablecost
AVC A AC1
P2 P1
B C
AR MR Q1 Output(Q)
Considerthecostandrevenuecurvesfacingabusinessintheshortruninthediagramabove.
Averagerevenue(AR)andmarginalrevenuecurves(MR)liesbelowaveragecostacrossthe
fullrangeofoutput,sowhateveroutputproduced,thebusinessfacesmakingaloss.
AtP1andQ1(wheremarginalrevenueequalsmarginalcost),thefirmwouldshutdownas
priceislessthanAVC.ThelossperunitofproducingisverticaldistanceAC.
IfthefirmshutsdownproductionthelossperunitwillequalthefixedcostperunitAB. Intheshortrun,providedthatthepriceisgreaterthanorequaltoP2,thebusinesscanjustify
continuingtoproduceintheshortrun. NorthernFoodsdecidestomothballafactory NorthernFoods,whichsuppliesMarksandSpencer,istomothballafactorymakingreadymeals becauseitisnolongereconomical.Theysaidthat,whilsttheplanthadbeenprofitableinrecent yearsitwasnolongergeneratingenoughmoneytogiveanadequatereturntoshareholders.Some analystshavearguedthatthedecisionmightbeduetotheeffectsofthemonopsonypowerofMarks andSpencerwhichhasdemandeddiscountsofupto6%fromitstopsuppliersincludingNorthern Foods. Source:Adaptedfromnewsreports,May2008 DerivingtheFirmsSupplyCurveintheShortRun Intheshortrun,thesupplycurveforabusinessoperatinginacompetitivemarketisthe marginalcostcurveaboveaveragevariablecost.
30
Inthelongrun,afirmmustmakeanormalprofit,sowhenprice=averagetotalcost,thisis thebreakevenpoint.Itwillthereforeshutdownatanypricebelowthisinthelongrun. Asaresultthelongrunsupplycurvewillbethemarginalcostcurveaboveaveragetotal cost. Theconceptofasupplycurveisinappropriatewhendealingwithmonopolybecauseamonopolyis apricemaker,notapassivepricetaker,andcanthusselectthepriceandoutputcombinationon thedemandcurvesoastomaximiseprofitswheremarginalrevenue=marginalcost. Changesindemandandtheprofitmaximisingpriceandoutput Achangeindemandand/orproductioncostswillleadtoachangeintheprofitmaximisingpriceand output.Inexamsyoumayoftenbeaskedtoanalysehowchangesindemandandcostsaffectthe equilibriumoutputforabusiness.Makesurethatyouareconfidentindrawingthesediagramsand youcanproducethemquicklyandaccuratelyunderexamconditions. InthediagrambelowweseetheeffectsofanoutwardshiftofdemandfromAR1toAR2(assuming thatshortruncostsofproductionremainunchanged).Theincreaseindemandcausesariseinthe marketpricefromP1toP2(consumersarenowwillingandabletobuymoreatagivenprice perhapsbecauseofariseintheirrealincomesorafallininterestrateswhichhasincreasedtheir purchasingpower)andanexpansionofsupply(theshiftinARandMRisasignaltofirmstomove alongtheirmarginalcostcurveandraiseoutput).Totalprofitshaveincreased.
Ariseindemand(ashiftinARandMR)causesanexpansionofsupply,ahigherprofitmaximising priceandanincreaseinsupernormalprofits
ProfitMaxatPriceP2 ProfitMaxatPriceP1
Costs
P2 P1 MC
AC
AC1 AC2 AR2

AR1 (Demand)
MR2 Q1 Q2 MR1 Output(Q)

31
Wisemandairieshitbyprofitsblow SharesinRobertWiseman,Scotlandsbiggestmilksupplier,havetakenahitfollowingnewsoflower profits.Operatingprofitswerereportedasfallingby16%aftera6.1mfineleviedbytheOfficefor FairTradingforallegedpricefixing.Thecompanyisalsosufferingfromtheeffectsofhigherenergy, packaginganddistributioncostscausedbytherisingworldpriceofoil.Athirdfactorisaslumpin themarketpriceofcream.Thecompanyhasfoundthatitcannotalwayspassonhigherinputprices tocustomers,partlybecauseofpreexistingmilkdeliverycontractswithsomeofthemajor supermarkets. Source:Adaptedfromnewsreports,May2008 TheFunctionsofProfitinaMarketEconomy Profitsserveavarietyofpurposestobusinessesinamarketbasedeconomicsystem 1. FinanceforinvestmentRetainedprofitsaresourceoffinanceforcompaniesundertaking investmentprojects.Thealternativessuchasissuingnewshares(equity)orbondsmaynot beattractivedependingonthestateofthefinancialmarketsespeciallyintheaftermathofthe creditcrunch. 2. Marketentry:Risingprofitssendsignalstootherproducerswithinamarket.Whenthe existingfirmsareearningsupernormalprofits,thissignalsthatprofitableentrymaybe possible.Incontestablemarkets,wewouldseeariseinmarketsupplyandlowerprices.But inamonopoly,thedominantfirm(s)maybeabletoprotecttheirpositionthroughbarriersto entry. 3. Demandforfactorresources:Scarcefactorresourcestendtoflowwheretheexpectedrate ofreturnorprofitishighest.Inanindustrywheredemandisstrongmoreland,labourand capitalarethencommittedtothatsector.Equallyinarecession,nationaloutput,employment, incomesandinvestmentallfallleadingtoasqueezeonprofitmarginsandattemptsby businesseslargeandsmalltocutcostsandpreservetheirmarketposition.Inaflexiblelabour market,afallindemandcanquicklyleadtoareductionininvestmentandcutbacksinlabour demand. 4. Signalsaboutthehealthoftheeconomy:Theprofitsmadebybusinessesthroughoutthe economyprovideimportantsignalsaboutthehealthofthemacroeconomy.Risingprofits mightreflectimprovementsinsupplysideperformance(e.g.higherproductivityorlowercosts throughinnovation).Strongprofitsarealsotheresultofhighlevelsofdemandfromdomestic andoverseasmarkets.Incontrast,astringofprofitwarningsfrombusinessescouldbealead indicatorofamacroeconomicdownturn.
32
NetProfitforManufacturingandServiceBusinesses
Netpercentagerateofreturnoncapitalemployed,seasonallyadjusted
22.0 20.0 18.0 16.0
Rateofreturn(%)
22.0 20.0
Services
18.0 16.0 14.0
14.0 12.0 10.0 8.0 6.0 4.0 2.0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07
Manufacturing
12.0 10.0 8.0 6.0 4.0 2.0
Source:ReutersEcoWin
Stepstohigherprofits Inanidealworld,runningabusinesswouldbeeasy!Youcomeupwithaninnovativeidea,createa newproductorservicesopopularyoucantstoppeoplefrombuyingit.Wordspreadsand,before youknowit,salesandprofitsaregrowing.Inreality,fewbusinessesareabletositbackandwatch theprofitsrollin.Creatingandincreasingprofitabilitydependsondoingahundredlittlethingsbetter thantheexistingcompetition.Sowhatarethebestwaysforabusinesstoincreaseitsprofitability? Method1:GrowtheTopLine Everybusinessandeverymarketisdifferent.Butformostbusinesses,thebestlongtermwayto improveprofitabilityistoincreasesales(alsoknownasturnover).Thisisforfourmainreasons: 1. Ifabusinesshasahighgrossprofitmargin,everyextrasaleisprofitable.Onceyour turnoverreachesthebreakevenleveltheneachadditionalsaleaddstoprofits. 2. Acquiringnewcustomersismadeeasierbygreatermarketpresenceandreputation.As yougrow,unitcostsarereducedthrougheconomiesofscale. 3. Ifyourcustomerstendtobeloyal,thevalueofeachnewcustomerlaysnotjustinthe immediatesale,butinfuturesalesaswell.Thecostofsellingtoexistingcustomersis alwayslowerthanthecostofacquiringnewcustomers. 4. Defendingamarketshareagainstcompetitorsiseasierthandefendinghighprofitmargins.
33
Manybusinessesoperateinwhatarecalledlowgrowthmarketswhereexpansiononlycomes bytakingabiggershareoftheavailabledemand.Lowgrowthmarketstendtobeinmarketswhere incomeelasticityofdemandislow,sothatastherealincomesofconsumersincrease,thereis littlepositiveeffectonmarketdemand. Method2:KeepCostsunderControl Ifabusinesshasalowgrossprofitmargin,reducingdirectcostsincreasestheprofitoneachsale. Eliminatingoverheadshasanimmediateimpactonprofit.Everybusinesscanincreaseprofitabilityby reducinghiddencosts.Hiddencostsincludethecostsofemployinginappropriatepeoplesincepoor recruitmentcanleadtolowerquality,increasedtrainingcostsandultimatelyredundancycosts. Suggestionsforfurtherreadingonprofits Aselectionofrecentnewsarticlesontheprofitabilityofbusinessesindifferentmarketsand industriesandhowchangesindemandandcostsaffectpricesandprofits. Dominosdeliversstrongerprofits(BBCnews,July2008) FuelcostseatintoFedexprofit(BBCnews,March2008) GrandTheftAutoIVsettobreakallrecords(BBCnews,April2008) Greggswarnsofincreasedcosts(BBCnews,March2008) HigheroilpricesseeBPsprofitssurge(Guardian,July2008) Pubscloseasbeersalesfall(BBCnews,July2008) Ryanairslashesfarestoboostdemandandfillairlinecapacity(Guardian,August2008) ShouldtheBritishpubgetagovernmentsubsidy?(BBCnews,July2008) Silverjetcallsinadministrators(BBCnews,June2008) SupporterscountthecostoffollowingaPremiershipfootieclub(Tutor2ublog,March2008) WeakdollarboostsNikeprofits(BBCnews,March2008) Wolseleyhitbyhousingslowdown(BBCnews,July2008)
34
6. WhatObjectivesDoFirmsHave?
Inthischapterweconsiderarangeofdifferent businessobjectivesmuchdependsonthe ownershipandcontrolofabusinessandthetypeof marketinwhichitoperates. Profitmaximisation Thetraditionaltheoryofthefirmtendstoassumethat businessespossesssufficientinformation,market powerandmotivationtosetpricesortheirproducts thatmaximiseprofits.Thisassumptionisnow criticisedbyeconomistswhohavestudiedthe organisationandobjectivesofmodernday corporations. Whymightabusinessdepartfromprofitmaximisation? Therearenumerouspossibleexplanations.Somerelateothelackofaccurateinformation requiredtoundertakeprofitmaximisingbehaviour.Othersconcentrateonthealternativeobjectives ofbusinesses.Westartfirstwiththeeffectsofimperfectinformation. Itmightbehardforabusinesstopinpointpreciselytheirprofitmaximisingoutput,astheycannot accuratelycalculatemarginalrevenueandmarginalcosts.Oftenthedaytodaypricingdecisionsof businessesaretakenonthebasisofestimateddemandconditions. Secondly,mostmodernbusinessesaremultiproductfirmsoperatinginarangeofseparate marketsacrosscountriesandcontinentsasaresultthevolumeofinformationthattheyhaveto handlecanbevast.Andtheymustkeeptrackoftheeverchangingpreferencesofconsumers.The ideathatthereisaneat,singleprofitmaximisingpriceisredundant. BehaviouralTheoriesoftheFirm Behaviouraleconomistsbelievethatmoderncorporationsarecomplexorganizationsmadeup variousstakeholders.Stakeholdersaredefinedasanygroupswhohaveavestedinterestinthe activityofabusiness.Examplesmightinclude: o Employeeswithinabusiness o Managersemployedbythefirm o Shareholderspeoplewhohaveanequitystakeinabusiness o Customersinthemarket o Thelocalcommunity o Thegovernmentanditsagenciesincludinglocalgovernment Eachofthesegroupsislikelytohavedifferentobjectivesorgoalsatpointsintime.Thedominant groupatanymomentcangivegreateremphasistotheirownobjectivesforexamplepriceand
35
outputdecisionsmaybetakenatlocallevelbymanagerswithshareholderstakingonlyadistant andimperfectlyinformedviewofthecompanysperformanceandstrategy. Iffirmsarelikelytomoveawayfrompureprofitmaximisingbehaviour,whatarethealternatives? 1. Satisficingbehaviourinvolvestheownerssettingminimumacceptablelevelsof achievementintermsofbusinessrevenueandprofit. 2. SalesRevenueMaximisation Theobjectiveofmaximisingsalesrevenueratherthanprofitswasinitiallydevelopedbytheworkof WilliamBaumol(1959).Hisresearchfocusedonthebehaviourofmanagercontrolledbusinesses. Baumolarguedthatannualsalariesandotherperksmightbecloselycorrelatedwithtotalsales revenueratherthanprofits.Companiesgearedtowardsmaximisingrevenuearelikelytomake frequentandextensiveuseofpricediscrimination(oryieldmanagement)asameansofextracting extrarevenueandprofitfromconsumers. 3. ManagerialSatisfactionmodel AnalternativeviewwasputforwardbyOliverWilliamson(1981),whodevelopedtheconceptof managerialsatisfaction(ormanagerialutility).Thiscanbeenhancedbyraisingsalesrevenue.
Costs ProfitMaxatPriceP1 RevenueMaxatPriceP2 AC P1 P2 MC
AC1 AC2
AR(Demand)
Q1
Q2
MR
Output(Q)
Priceandoutputdiffersifthefirmchangesitsobjectivefromprofittorevenuemaximisation. Assumingthatthefirmscostsremainthesame,afirmwillchoosealowerpriceandsupplyahigher outputwhensalesrevenuemaximisationisthemainobjective. TheprofitmaximisingpriceisP2atoutputQ2whilsttherevenuemaximisingpriceisP1atoutput Q1. Achangeintheobjectivesofthebusinesshasaneffectonwelfareandinparticularthebalance betweenconsumerandproducersurplus.Consumersurplusishigherwithsalesrevenue maximisationbecauseoutputishigherandpriceislower.
36
Cadburyabandonsitsprofittarget CadburySchweppesPlc,themanufacturerofDairyMilkchocolatehasdecidedtoscrapits profitabilitytargetinthewakeofasharpincreaseinthecostsoftheirrawmaterials.Threeyearsago Cadburyannouncedtargetsforannualimprovementsinprofitmarginsrangingfrom0.5to0.75%. Buttherisingpriceofoilbasedrawmaterialsandtheworldmarketpriceofcocoaandsugarhave conspiredtomakemeetingthistargetimpossible.Prospectsforprofitshavealsobeenadversely affectedbythehotsummerwhichhashitdemandforchocolateandtheunplannedrecallofseveral highprofileproductsbecauseoffearsofsalmonellapoisoning.Thebusinessisamajorglobal presenceintheconfectionerymarketwithanestimatedtenpercentworldmarketshare.InJune 2007,Cadburyannouncedthatitplannedtocutitsworkforceby15%.Thereorganisationwillcost Cadburyabout450minaoneoffcharge. AdaptedfromTutor2ublog,November2006andnewsreports,June2007 SocialEntrepreneursnotjustforprofitbusinesses Underneaththesurfaceofaneconomydominatedbycorporategiants,anewbreedofbusinessis flourishing,whereprofitisnotalwaysthebottomlinetheseareentrepreneursoperatingforasocial purposeandnotjustforprofit.Asocialenterpriseisabusinessthathassocialobjectiveswhose surplusesarereinvestedforthatpurposeinthebusinessorthecommunity,ratherthanbeingdriven bytheneedtoseekprofittosatisfyinvestors.Ratherthanmaximiseshareholdervalueanddistribute dividends,asocialenterpriseislookingtoachievesocialandenvironmentalaimsoverthelongterm. Examplesinclude o o o o o SocialEntrepreneurship AnexamplefromIndia DeviPrasadShettystrivestomakesophisticatedhealthcareinIndiaavailabletoallirrespectiveof theireconomicsituationorgeographiclocation.HefoundedtheNarayanaHrudayalayaHospitalin Bangalorein2001andcofoundedtheAsiaHeartFoundation.Inaddition,Shettyhasbuilta networkof39telemedicinecentrestoreachouttopatientsinremoteruralareas.Together,the networkofhospitalsperforms32heartsurgeriesaday.Almosthalfthepatientsarechildrenand babies.Sixtypercentofthetreatmentsareprovidedbelowcostorforfree. AndonefromtheUK The2008IndependentSocialEntrepreneuroftheYearawardwenttoBeluWater,abottledwater companythatdonatesallofitsprofitstoglobalcleanwaterprojects.Thecompanyusescarbon neutralpackagingintheformofacompostablebottlemadefromcorn.Beluisthefirstcarbon neutralproductbeingstockedatTesco.Thebottleslooklikeordinarybottlesandcanberecycled withplasticsorcommerciallycompostedbacktosoilinjusteightweeks.Amongitscleanwater projects,Beluhasinstalledhandpumpsandwellsfor20,000peopleinIndiaandMali,anditis alsoworkingonarubbishmunchertocleanuptheThames.Thecompanyhasapledgethateach bottleofmineralwatersoldwilltranslateascleanwaterforonepersonforonemonth.
CafDirect FairTrade Traidcraft DivineChocolate TheEdenProject
o FifteenFoundation(JamieOliver) o HousingAssociations o Microcreditdevelopedbythe GrameenBankanditsfounder,the NobelPrizewinnerMuhammadYu
37
Source:Adaptedfromnewsreports,January2008 SeeYoung,GiftedandnotforProfit(BBCradio4InBusiness)andalsotheeconomicimpactof theEdenproject.Othergoodsitesinclude:SchwabFoundationforSocialEntrepreneurship NotforProfitBusinesses Thesearecharities,communityorganisationsthatarerunoncommerciallinese.g.NetworkRail: NetworkRail TookovertherailnetworkinOctober2002 Statedpurposeistodeliverasafe,reliableandefficientrailwayforBritain. Itisacompanylimitedbyguaranteewhosedebtsaresecuredbythegovernment NetworkRailisaprivatecompanyoperatingasacommercialbusinessandregulatedby theOfficeofRailRegulation o NetworkRailisa"notfordividend"company,whichmeansthatallofitsprofitsareinvested intherailwaynetwork. o TrainoperatingcompaniespayNetworkRailforuseoftherailinfrastructure o o o o Businessesrequiredtomainalossmakingserviceonsocialgrounds AgoodexamplehereistheRoyalMailwhichisrequiredtomaintainauniversalnationalpostal deliveryservicethroughouttheUKforauniformprice.Householdmailmakesaloss,cross subsidisedbybusinessmailalthoughthismarketisshrinkingfortheRoyalMailbecauseofthe introductionoffreshcompetitionfromJan2006.ThePostOfficeLtdisasubsidiaryoftheRoyal MailGroupplcitrunssubstantiallossesonthenetworkorruralpostofficesandhasbeenunder greatpressuretoclosehundredsofofficestostemlosses. Suggestionsforfurtherreadingonbusinessobjectivesandbusinessownership AustralianexpansionprovesamovetoofarforStarbucks(Tutor2ublog,July2008) FounderofbottledwatercompanyhonouredforworkinThirdWorld(Independent,Jan2008) Howbusinessembracedcharity(TheObserver,June2008) Makingprofitwithaconscience(BBCnews,March2008) Motivatedbychange(Independent,July2004) Mysteriousdeathofthepetrolstation(VVCnews,March2008) NetworkRailannouncespretaxprofitof1.6bn(BBCnews,June2008) Ryanairfliesintothepathofaneconomicstorm(Tutor2ublog,July2008) SonypredictsTVandgameprofits(BBCnews,June2008) Survivalchallengeforsocialenterprises(Guardian,July2008) Windfarmcoopraisesthousands(BBCnews,July2008)
38
7. DivorcebetweenOwnershipandControl
Ownershipandcontrol Theownersofaprivatesectorcompanynormallyelectaboardofdirectorstocontrolthe businesssresourcesforthem.However,whentheownersellsshares,ortakesoutaloanorbond toraisefinance,theymaysacrificesomeoftheircontrol.Othershareholderscanexercisetheir votingrights,andprovidersofloansoftenhavesomecontrol(security)overtheassetsofthe business. Thismayleadtoadegreeofconflictbetweenthemasthesedifferentstakeholdersmayhave differentobjectives.Theflowchartbelowattemptstoshowthedivorcebetweenownershipand control.
Principals: Shareholders OWNERSHIP
ControlMechanisms: Pressuresfromthestockmarket andfromhedgefundsandprivate investors Regularmeetingswith shareholders(e.g.theAGM) Scrutinyinthefinancialpress Performancerelatedpay(to provideincentives) Agents: BoardofDirectors SeniorManagement CONTROL
ThePrincipalAgentProblem Howdotheownersofalargebusinessknowthatthemanagerstheyhaveemployedandwhoare makingthekeydaytodaydecisionsoperatewiththeaimofmaximisingshareholdervalueinboth theshorttermandthelongrun? Thislackofinformationisknownastheprincipalagentproblemoragencyproblem.Inother words,oneperson,theprincipal,employsanagent(e.g.asalesorfinancemanager)toperform tasksonhisbehalfbutheorshecannotensurethattheagentalwaysperformstheminprecisely thewaytheprincipalwouldlike.Thedecisionsandtheperformanceoftheagentareboth impossibleandexpensivetomonitorandtheincentivesoftheagentmaydifferfromthoseof theprincipal.Theprincipalagentproblemisillustratedintheflowchartabove.
39
ExamplesoftheprincipalagentproblemthathavehittheheadlinesrecentlyintheUKincludethe mismanagementoffinancialassetsonbehalfofinvestors(e.g.thecasesurroundingEquitable Life)andthemanagementofcompaniesonbehalfofshareholders(e.g.duringtheturbulentyears experiencedbyMarksandSpencerandShell).TheclassiccaseintheUnitedStatesisofcourse theEnronfraudanddebacle.FollowthisBBCnewslinkformorebackgroundontheEnroncase. Manyinvestorsinabusinessare'passive',theymightmonitortheperformanceofthecorporation byfollowingthenewsinthefinancialpressand(occasionally)attendingandvotingatannual generalmeetingsbuttheirdirectinvolvementislimitedandunlikelytohaveabearingonthe crunchdecisionsofthebusiness.ThebiggestinvestorsinUKlistedcompaniestendtobelarge institutionalshareholderssuchaspensionfundsandinsurancecompanies. IncentivesMatter!EmployeeShareOwnershipSchemes Therearevariousstrategiesavailableforcopingwiththeprincipleagentproblem.Oneistherapid expansionofemployeeshareownershipschemesandshareoptionsprogrammes.The governmenthasencouragedthewideruseofshareownershipschemesthroughaseriesoftax incentives.Buttheuseandoccasionalmisuseofshareoptionsschemeshasbeencontroversial forseveralyears.ArecentexampleinvolvedtheUScomputergiantApple. Thegrowthof"shareholderactivism" Manycommentatorsquestiontheassumptionthatshareholdersplaylittledirectroleininfluencing corporatestrategyinmoderncorporations.Thereareplentyofexamplesinrecenttimeswhenboth institutionalandindividualshareholdershaveexercisedtheirvotingrightstoexpressviewson thedirectionthatacompanyistakingoritsperformance.Typicallytheyarecriticalofaperceived failureofabusinesstomaximiseshareholdervaluemeasuredintermsofshareprice,theflowof dividendincomesetc. Increasinglyweareseeinganewbreedofshareholderswhoareseentobemuchmoreproactive inputtingexecutivemanagementunderpressuretheseareknownasactivistshareholders.At theforefrontofthischangehasbeentheexpansionofprivatehedgefundsandanumberofhigh profileandverywealthyprivateinvestors.Latterly,thesovereignwealthfundshaveappearedon thescene. Anactivistshareholderusesanequitystakeinacorporationtoputpressureonitsexisting management.Thegoalsofactivistshareholdersrangefromfinancial(increaseofshareholder valuethroughchangesindividenddecisions,plansforcostcuttingorcapitalinvestmentprojects etc.)tononfinancial(disinvestmentfromparticularcountrieswithapoorhumanrightsrecord,or pressuringabusinesstospeeduptheadoptionofenvironmentallyfriendlypoliciesandbuilda betterreputationforethicalbehaviour,etc.). Activistshareholdersdonothavetoholdlargestakesinabusinesstomakeanimpact.Eventhose withrelativelysmallstakesor3or4percentcanlaunchpublicitycampaignsandmakedirect contactwiththeseniormanagement.Privateequity/hedgefundshavebeenamongthosemost involvedintheriseofshareholderactivism.Theytendtofocusonunderperformingbusinesses Isthisnewbreedofshareholderactivistsanimportantvoiceandcounterbalancetothepowerof entrenchedmanagementandwillingtostanduptocorporatecorruptionandhighlightpoor management?Cantheyhelptoovercometheprincipleagentproblem?Oraretheymerely aggressivecorporateraidersseekingshorttermcorporatechangemerelyfortheirownpersonal gain?
40
EnvironmentalgroupssuchasFriendsoftheEarthhavealsolatchedontothepotentialfor shareholderactivismtoimpactonbusinessesespeciallyintheareasoftheenvironmentalimpact oftheirbusinessactivities. ThatsaiditremainsthecasethatthepatternofownershipandcontrolwithinBritishindustryis dispersed.Typicallythelargestshareholderinanylargebusinesslistedonthestockmarketis likelytoownaminorityoftheshares.Majorityownershipbyasingleshareholderisunusual. Examplesofrecentshareholderactivism Sainsbury's:In2004,athirdofJSainsbury'sshareholdersvotedagainstthe supermarket'spaypolicy,objectingtoitsdecisiontogivea2.3mbonustoousted chairmanSirPeterDavis.Sainsbury'ssubsequentlydecidedtocancelthecontroversialpay award.SirPeterDavisquitSainsbury'safteragroupofmajorinstitutionalshareholders demandedmanagementchanges.HewasreplacedbyJustinKing. Disney:In2004,MichaelEisner,thechairmanandchiefexecutiveofDisney,resigned after43%ofDisneyshareholdersvotedagainsthisreelection. EuroTunnel:In2004,themanagementboardofEuroTunnelwasoustedatthecompany's AGM. Vodafone:InMayof2006,VodafoneannouncedthebiggestlossinBritishcorporate history(14.9billion).InJuly2006,theCEOofVodafoneArunSarincameunderhuge pressurefromagroupofshareholdersunhappyabouttheperformanceofthestruggling telecomscompany.Intheevent,shareholdersvoted86%infavourofMrSarin,with9.5% votingagainst,and4.5%abstaining. DaimlerChrysler:InApril2007,about9,000shareholdersattendedtheGermanUS carmaker'sannualmeetingandvoicedstrongcriticismsofthebusinessesperformance. Manyshareholdersstoodupduringthemeetingtocondemnthetransatlanticmergerwhich tookplacebetweenDaimlerBenzandChryslerin1998. MotorolaversusCarlIcahn:ThefinancierCarlIcahnhasareputationasoneofthe leadingshareholderactivists.HehasbeeninabattlewithMotorolaovertheirstrategy. PhotoMe:InOctober2007thechairmanandchiefexecutiveofthepassportbooth operatorPhotoMeagreedtoquitinthefaceofgrowingopposition Morereadingonshareholderactivism: Hailshareholder!(TheEconomistMay2007) Ownerdrivers(TheEconomist,May2007) CorporateSocialResponsibilityandBusinessEthics Businessethicsisconcernedwiththesocialresponsibilityofmanagementtowardsthefirms stakeholders,theenvironmentandsocietyingeneral.Thereisagrowingbeliefthatethicaland greenbusinessarelinkedtoimprovedbusinessperformancebecauseofincreasedpublic concernforhumanrightsandtheenvironment.Manybusinessesarenowtrumpetingtheir progressinmakingtheiractivitiescarbonneutralbyoffsettingtheimpactoftheirproduction activitiesontheirenvironmentthroughoffsetactivities.BusinessessuchasCarbonClearprovidea meansbywhichorganisationscanfindwaystooffsettheircarbonemissions. Businessethicsextendstotreatingstakeholdersfairlyhencethegrowingemphasisonhealth andsafetyissues,goodworkingpracticesandthelikeinbusinessdecisionmaking.
41
FormorereadingonthistrythislinktotheInstituteforBusinessEthics.TheTimes100Case StudiesincludesoneonCadburysandcorporatesocialresponsibility.ClickhereforBBCnews articlesoncarbonneutrality. Suggestionsforfurtherreadingonbusinessownershipandcontrol StuartRosefacesshareholderrevoltatM&Sannualmeeting(Guardian,June2008) NapstershareholdersrevoltoveriTunesfailure(NewZealandHerald,June2008) Yellchiefsfaceinvestorrevoltoverbigbonuses(TheTimes,July2008)
42
8. TechnologicalChange,CostsandSupplyintheLongrun
Whatisinnovation? TheOxfordEnglishDictionarydefines innovationasmakingchangesto somethingestablished.Invention,by contrast,istheactofcominguponor finding:discovery.Innovationsfrequently disruptthewaythatbusinessesdothings andmayhavebeendoingsoforyears. Productinnovationisadrivingdynamicin mostmarketsconsiderforexamplehow importantinnovationisinthesemarkets: o Telecommunications o Pharmaceuticals o Transport o Audiovisualproducts o Marketsforlowcarbonproducts o Farming(importantatthistimegiventheglobalfoodcrisis) Productinnovationisoftenassociatedwithmanysmall,subtlechangestothecharacteristics andperformanceofaproduct.Groundbreakingproductinnovationappearstobecomingrarer despitethebillionsofdollarsspenteachyearbyglobalpharmaceuticalcompaniesandhousehold goodsmanufacturers. Newmarketsandsynergydemand: Productinnovationcreatesnewmarkets,especiallywhennewtechnologycreatesradically differentproductsforconsumers.Innovationisalsoasourceofsynergydemand.Forexample, Gillette(abusinessunitofProctorandGamble)launchedin2004thesuccessortoitstopbranded producttheMach3andMach3turborazor.Thenewwetshaverazorisbatterypowered handygiventhatGillettealsoownstheDuracellbrand! Sustaininganddisruptiveinnovations Manynewproductsaresimilartoexistingonesonthemarketcompaniesareoftensatisfiedwith sustaininginnovationsratherthandisruptiveinnovationswhichhavethepowertoupset thestatusquoandmakeseriousinroadsintothemarketshareofwellestablishedbusinesses. JosephAloisSchumpeterfamouslymadereferencetoinnovationcreatinggalesofcreative destruction. Examplesofdisruptiveinnovations: o Emergenceofthelowcostairlinesfollowingaradicallydifferentbusinessmodelthishas hadahugeeffectonnationalscheduledairlinecarrierssuchasBritishAirways. o ConsideronlinemusicdownloadbusinessessuchasiTunesandpeertopeerfilesharing. o VoiceoverInternetProtocolVoIPsuchasSkypeversustraditionaltelephoneandmobile phoneserviceproviders.
43
Gainsindynamicefficiency: Dynamicefficiencyoccursovertime.Itfocusesonchangesinconsumerchoiceavailableina markettogetherwiththequality/performanceofgoodsandservicesthatwebuy.Innovation canstimulateimprovementsindynamicefficiency,alwaysprovidingthattheinnovationsthatcome tomarketareappropriateinsatisfyingourchangingneedsandwants Innovationasabarriertoentry Innovativebehaviourcanbeanimportantbarriertoentryinmarkets.Firstlybecausesomethe propertyrightsembeddedinproductinnovationsmightbeprotectedbypatentlaws.Thereis nearlyalwaysafirstmoveradvantageforsuccessfulinnovatorsthatgivesthemscopeto exploitsomemonopolypowerinamarket. Setagainstthisargumentisthatviewthathighratesofinnovationreducebarrierstoentrybecause theychallengeexistingmarketpowerenjoyedbywellestablishedbusinesses. Processinnovation Processinnovationsinvolvechangestothewayinwhichproductiontakesplace,beitonthe factoryfloor,businesslogisticsorinnovativebehaviourinmanagingemployeesintheworkplace. Theeffectscanbebothonafirmscoststructure(i.e.theratiooffixedtovariablecosts)aswell asthebalanceoffactorinputsusedinproduction(i.e.labourandcapital).
MC1
Costs
P1 SRAC1
ProfitatPriceP1 ProfitatPriceP2
SRAC3 P2 MC2
AR (Demand) MR Q1 Q2 Output(Q)
Costreducinginnovationscauseanoutwardshiftinmarketsupplyandtheyprovidethescope forbusinessestoenjoyhigherprofitmarginswithagivenlevelofdemand.Processinnovation shouldalsoleadtoamoreefficientuseofresources. Thediagramaboveusescostandrevenuecurvestoshowtheeffectofdrivingdownproduction costsfromSRAC1toSRAC2leadingtolowerpricesandahigheroutput.Youcouldalsousethis diagramtoshowthegainsinproducerandconsumersurplusthatcomefromcostreducing innovationandtechnologicalchange.Consumersstandtogainfromsuchinnovationinthatthey shouldbeabletoexpectlowerprices.Thisincreasestheirrealincomes.

44
Governmentpolicyandinnovation Supplysidestrategiesareusuallylinkeddirectlywithattemptstopromotemoreinnovative behaviour.Indeedthefocusofgovernmentpolicyisfirmlyfocusedonimprovementsinthe microeconomicsofmarkets. Whichpoliciesmightencouragemoreinnovation? o Taxcredits/capitalinvestmentallowances. o Policiestoencouragesmallbusinesscreationandentrepreneurship. o Tougheningupofcompetitionpolicytoexposecartelbehaviour,buttoallowandpromote jointventurestofundresearchanddevelopment. o LowercorporationtaxestoencourageinnovativeforeigncompaniestoestablishinBritain. o Increasedfundingforresearchinouruniversities. Importantdevelopments: 1. Increasinglymostinnovationisdonebysmallerfirmsandbyentrepreneursindeed multinationalcorporationsarenowoutsourcingtheirresearchanddevelopmentspending tosmallbusinessesathomeandoverseasmuchisbeingshiftedtocheaperlocations offshoreinIndiaandRussia.SeethisarticleonentrepreneurshipintheEconomist. 2. Innovationisnowacontinuousprocessinpartbecausethelengthoftheproduct cycleisgettingshorterasinnovationsarerapidlycopiedbycompetitors,pushingdown profitmarginsand(accordingtoarecentarticleintheeconomist)transformingtoday's consumersensationintotomorrow'scommonplacecommodityagoodexampleofthisis theintroductionoftwomajorcompetitorstotheantiimpotencedrugViagra! 3. Innovationisnotsomethinglefttochancethemostsuccessfulfirmsarethosethat pursueinnovationinasystematicfashionitbecomespartoftheircorporateculture. 4. Demandinnovationisbecomingmoreimportant:Inmanymarkets,demandiseither stableorindecline.Theresponseistogofordemandinnovationdiscoveringfresh demandfromconsumersandadaptinganexistingproducttomeetthemthetoyindustry isaclassicexampleofthis. Suggestionsforfurtherreadingontheeconomicsofinnovationandtechnologicalchange Britainsbrilliantideasboom(MoneyProgramme,November2007) InnovationistransformingNHScare(BBCnews,July2008) Microsoftssurvivalstrategy(BBCnews,May2008) SecretofBillGatessuccess(MoneyProgramme,June2008) Themanyfacesofinnovation(TheEconomist,July2008) Thetechnologyofteaching(BBCnews,March2008) Videogamesmakehistoryin2007(BBCnews,December2007) Xeroxplansthefutureoftoday(BBCnews,May2008)
45
9. TheGrowthofFirms
Whydofirmsseektogrow? Thefollowingfactorsarecommonly associatedwiththedesireoffirmsto grow: 1. Theprofitmotive:Businesses growtoexpandoutputand achievehigherprofit.The stimulustoachieveyearonyear growthisoftenprovidedbythe expectationsplacedona businessbythecapitalmarkets. Thestockmarketvaluationofa firmisinfluencedby expectationsoffuturesalesandprofitstreamssoifacompanyachievesdisappointing growthfigures,thismightbereflectedinafallinacompanysshareprice.Thisopensup theriskofahostiletakeoverandmakesitmoreexpensiveforaquotedcompanytoraise freshcapitalbyissuingnewsharesontothemarket. 2. Thecostmotive:Economiesofscalehavetheeffectofincreasingtheproductive capacityofthebusinessandtheyhelptoraiseprofitmargins.Theyalsogiveabusiness acompetitiveedgeindomesticandinternationalmarkets. 3. Themarketpowermotive:Firmsmaywishtogrowtoincreasetheirmarketdominance therebygivingthemincreasedpricingpowerinspecificmarkets.Monopoliesforexample canengageinpricediscrimination. 4. Theriskmotive:Theexpansionofabusinessmightbemotivatedbyadesiretodiversify productionsothatfallingsalesinonemarketmightbecompensatedbystrongerdemand andoutputinanothermarket. 5. Managerialmotives:Behaviouraltheoriesofthefirmpredictthatthegrowthofabusiness isoftenspurredonbythedecisionsandstrategiesofmanagersemployedbyafirmwhose objectivesmightbedifferentfromthosewithanequitystakeinthebusiness. Howdofirmsgrow? Organicgrowth Thisisalsoknownasinternalgrowthandcomesaboutfromabusinessexpandingitsown operationsratherthanrelyingontakeoversandmergers.Organicgrowthmightcomeaboutfrom: Expansionofexistingproductioncapacity Investmentinnewcapital&technology Addingtotheworkforce Developing&launchofnewproducts Growingacustomerbasethroughmarketing
46
Externalgrowthofabusiness Thefastestrouteforgrowthisthroughintegrationi.e.throughmergersorcontestedtakeovers.In recentyearstherehasbeenaboominmergerandtakeoveractivity. Horizontalintegration:Horizontalintegrationoccurswhentwobusinessesinthesameindustryat thesamestageofproductionbecomeoneforexampleamergerbetweentwocar manufacturersordrinkssuppliers.Recentexamplesofhorizontalintegrationinclude: NikeandUmbro BodyShopandL'Oreal NTLandTelewest(newbusinesseventuallyrenamedasVirginMedia) CapitalRadioandGWRtoformGCap AOLandBebo TataandJaguar VirginActiveandHolmesPlace BritishAirwaysandIberiaAirlines Theadvantagesofhorizontalintegrationincludethefollowing: 1. Increasesthesizeofthebusinessandallowsformoreinternaleconomiesofsalelower longrunaveragecostsimprovedprofitsandcompetitiveness 2. Onelargefirmmayneedfewerworkers,managersandpremisesthantwoaprocess knownasrationalizationagaindesignedtoachievecostsavings 3. Mergersoftenjustifiedbytheexistenceofsynergies 4. Createsawiderrangeofproducts(diversification).Opportunitiesforeconomiesofscope 5. Reducescompetitionbyremovingrivalsincreasesmarketshareandpricingpower Verticalintegration:VerticalIntegrationinvolvesacquiringabusinessinthesameindustrybutat differentstagesofthesupplychain.Examplesofverticalintegrationmightincludethefollowing: Filmdistributorsowningcinemas Brewersowningandoperatingpubs Touroperators/CharterAirlines/TravelAgents Crudeoilexplorationallthewaythroughtorefinedproductsale Recordlabels,recordstations Sportswearmanufacturersandretailers Themainadvantagesofverticalintegrationare: 1. Greatercontrolofthesupplychainthishelpstoreducecostsbyeliminatingintermediate profitmargins 2. Improvedaccesstoimportantrawmaterials 3. Bettercontroloverretaildistributionchannels
47
LateralIntegration Thisinvolvessubsidiarycompaniesjoiningtogetherthatproducesimilarbutrelatedproducts. Goodrecentexamplesinclude: eBayandSkype GoogleandYouTube GilletteandProctor&Gamble Othersourcesofmonopolypower Monopolypoweralsocomesfromowningpatentsandcopyrightprotectionorexclusive ownershipofproductiveassets(e.g.DeBeersdiamonds).Monopolypowercanalsocome fromwinningbiddingracesforexclusiveagreementsthebestexampleofwhichisprobablythe monopolyonbroadcastinglivesoccergamesonTVownedbyBSkyBasaresultofwinning auctionsorganisedbythePremierLeague. Thegovernmentanditsagenciesmayalsogivelegalmonopolypowertosomebusinessthrough franchisesandlicences.Monopolypowercanofcoursecomeorganicallythroughinternal growthwhereafirmtakesadvantageofeconomiesofscale. Stobartpowerson Undeterredbyrisingfuelcostsandsignsofaneconomicslowdown,StobarttheUKslargestroad haulierhascontinuedtoexpandpostinga27%riseinrevenuesoverthelastyear.Thebusiness nowoperates1,500trucksand2,900trailersandhasworkedat81%capacityutilisation,upfrom 71%fouryearsago.StobarthasgrownexternallybymergingwithfellowhaulierWestburyand acquiringOConnor,theinlandcontainerterminaloperator.Stobarthasalsopurchasedtransport engineerWADevelopmentsandhastakenanoptiononbuyingCarlisleAirport.Thebusinesshas astrategyofbuildingamutlimodalcapabilitymixingroad,rail,seaandairtransport. Source:Adaptedfromnewsreports,June2008 Outsourcing Thetendencyofcompaniestooutsourcesomeoftheirproductionoperationsoverseashas becomeanimportantissueinrecentyears.Over30%ofUKcompaniesnowdosomeoftheir productionworkabroad,whilst10%haveoverhalfoftheirmanufacturingoffshoreinlowercost locations.Dysonisahighprofileexampleofacompanythathasrelocatedproductionabroadto Malaysia,whilstkeepingtheirresearchanddesignoperationsintheUK.Mostrecentlyweare witnessingatrendforservicesectorbusinessestofollowsuit.Inrecenttimeswehaveseen NorwichUnion,AbbeyNational,Tesco,BritishAirwaysandNationalRailEnquiriesalltransfer partsoftheiroperationoverseas. Therearethreemaindriverspromotingoutsourcingasabusinessstrategy: (1) TechnologicalchangeInformation,communicationandtelecommunicationcostsare fallingthismakesitmucheasiertooutsourcebothserviceandmanufacturingoperations tosubcontractorsinothercountries.Technologicaladvancesnowpromote"Justintime delivery"inventorystrategiesforthedeliveryofcomponentsandfinishedproductsand encouragethedevelopmentof"virtualmanufacturing".Communicationcostsaredropping
48
sharplytheaveragepriceofaoneminuteinternationalcallwas74%lowerin2003thanin 1993. (2) Increasedcompetitioninalowinflationenvironmentwhichincreasesthepressureon businessestoachievelowercostsasameansofmaintainingmarketshare. (3) Pressurefromthefinancialmarketsforbusinessestoimprovetheirprofitability. Formanylargebusinesses,thereareclearcostadvantagestobegainedthroughdoingbusiness viaacallcentrelocatedoverseas.Outsourcingisnotsimplyconfinedtoservicesectorindustries. Manymanufacturingbusinessesareusingoutsourcingasameansofreducingtheircosts, providinggreaterflexibilityofproductionlevelsattimesofvolatiledemandandalsoinspeedingup thetimeittakestogettheirgoodstomarket,especiallynewproducts. JointVentures Jointventuresoccurwhentwoormorebusinessesjointogethertopursueacommonprojector goal.Thistypeofbusinessagreementisbecomingcommonespeciallyasfirmsbecomeawareof thepotentialofcollaborativeworkinreachingamutuallystrategictarget.Firmsmightcome togetherforjointresearchprojectse.g.insharingsomeofthefixedcostsofexpensiveresearch projects. Goodexamplesofjointventuresinclude: SonyEricssonmobilephonejointventure GoogleandNASA Hollywoodstudiosfightinginternetpiracy HugoBossandProctor&Gamble BoeingandLockheed MySpaceandSkype RenaultNissansjointventurewithIndianfirmBajajtoproducea1,276car Evaluationcommentsonmergersandtakeovers Manytakeoversandmergersfailtoachievetheiraims. 1. Financialcostsoffundingtakeoversincludingtheburdenofdealsthathavereliedheavily onloanfinance 2. Theneedtoraisefreshequitytofundadealwhichcanhaveanegativeimpactona company'sshareprice 3. Manymergersfailtoenhanceshareholdervaluebecauseofclashesofcorporatecultures andafailuretofindtheallimportant"synergygains 4. Withthebenefitofhindsightweoftenseethewinnerscursei.e.companiespayingover theoddstotakecontrolofabusinessandendingupwithlittlerealgaininthemediumterm. 5. Competitionpolicyconcernscancomeintoplayespeciallywhenthereisariskofmonopoly powerfromverticalandhorizontalintegration 6. Integrationoftenleadstosizeablejoblosseswitheconomicandsocialconsequences
49
Thesurvivalofsmallerbusinessesintheeconomy Overtimethereisacleartrendtowardslargerscalebusinessoperationspartlybecauseofthe pressuresofcompetitiontheneedtoachieveeconomiesofscaleandtheeffectsofmergersand takeovers.Howeverthisprocessisnotpurelyaonewaystreet.Thereareplentyofexamples wherebusinessesaredemerginganddivestingthemselvesofsomeoftheirexistingassets.And eveninindustrieswheregiantbusinessesdominatethemarketplace,thereisfrequentlyroomfor smallerfirmstocompeteandsurviveprofitably. 1. Manysmallerbusinessescanmakeprofitsbyactingasasupplier/subcontractortolarger enterprises 2. Theymighttakeadvantageofalowpriceelasticityofdemandandhighincomeelasticityof demandforspecialistnichegoodsandservices 3. Smallerbusinessesareoftenhighlyinnovative,flexibleandcanavoiddiseconomiesof scale Privateequity Privateequityisthenamegiventoaparticulartypeofcompanyownership.Somebusinessessuch asTescoplcorBritishPetroleumplcarepubliclyownedbyoutsideinvestorswhocanbuyandsell theirsharesonthestockmarket.Incontrast,privatelyownedfirmsareownedbygroupsof individualsorfamiliesandalsobyprivateequityfunds.Thesefundsraisecapitalfrominstitutions suchaspensionfundsandmakeinvestmentsincompaniesthattheyfeelcanbeimprovedand achievehigherprofits. SomeofthebetterknownprivateequityfirmsincludePermira,KKR(Kohlberg,Kravisand Roberts)and3i.Inrecentyears,privateequityfirmshaveacquiredastringofwellknownbusiness namesintheUKrangingfromBirdsEyefrozenfoodstoSagaholidays,fromFitnessFirstgymsto MadamTussaudsGroup.Somecommentatorshavecalledthemcasinocapitalistsborrowing heavilytofundtakeoverbidsforcompaniesandthenengaginginsevereassetstrippingtorealise thevaluesofnewlyboughtbusinesses.Defendersofprivateequitybelievethattheycanprovidea meansbywhichinefficientmanagementisremovedandthatsuccessfultakeoverscancreate manymorejobsthantheyloseoverthemediumterm. Demergers Ademergeristheoppositeofamergeroracquisitionandhappenswhenabusinessdecidesto spinoffoneormoreofthebusinessesthatitownsintoaseparatecompanythismighttakethe formofamanagementbuyout.Ademergermaybefull,orpartial.Apartialdemergermeansthat theparentcompanyretainsastake(sometimesamajoritystake)inthedemergedbusiness.The aimisnearlyalwaystoimproveshareholdervaluebygivingnewmanagementtochancetofocus onaparticularcorebusinessandalsotoreducelevelsofdebt.Demergerscanalsoresultfrom governmentinterventionperhapsbecausethecompetitionauthoritieswantabusinesswith monopolypowertobebrokenuptosomeextenttomaintaincompetition. Examplesofrecentdemergers 1. DemergerofCadbury'sNorthAmericandrinksbusinesscreatinganewbusinesscalledDr PepperSnappleGroup(DPSG)
50
2. SevernTrentWaterdemergeditswastemanagementbusinessBiffa 3. DemergerofBritishGasintotheUKgaspipelinebusinessTranscoandaninternationaloil andgasexplorationcompany 4. WoolworthswasdemergedfromKingfisher Suggestionsforfurtherreadingonthegrowthoffirms Amazonbossonprofitsrise(BBCnews,July2008) Cadburytogoaheadwithsplit(BBCnews,August2007) Clubbingtogethertobeatthebigboys(BBCnews,July2008) CoopbuysSomerfieldfor1.57bn(BBCnews,July2008) FacehookedthegrowthofFacebook(MoneyProgramme,December2007) OrganicgrowthforCosta(Tutor2ublog,April2008)
51
10.
PerfectCompetition
Perfectcompetitionapuremarket Perfectcompetitiondescribesamarketstructurewhoseassumptionsarestrongandtherefore unlikelytoexistinmostrealworldmarkets. Economistshavebecomemoreinterestedinpurecompetitionpartlybecauseofthegrowthofe commerceasameansofbuyingandsellinggoodsandservices.Andalsobecauseofthe popularityofauctionsasadeviceforallocatingscarceresourcesamongcompetingends. Assumptionsforaperfectlycompetitivemarket 1. Manysmallfirms,eachofwhomproducesalowpercentageofmarketoutputandthus exercisesnocontrolovertherulingprice. 2. Manyindividualbuyers,noneofwhomhasanycontroloverthemarketpricei.e.there isnomonopsonypower. 3. Perfectfreedomofentryandexitfromtheindustry.Firmsfacenosunkcostsand entryandexitfromthemarketisfeasibleinthelongrun.Thisassumptionmeansthatall firmsinaperfectlycompetitivemarketmakenormalprofitsinthelongrun. 4. Homogeneousproductsaresuppliedtothemarketsthatareperfectsubstitutes.This leadstoeachfirmsbeingpricetakerswithaperfectlyelasticdemandcurvefortheir product. 5. Perfectknowledgeconsumershaveallreadilyavailableinformationaboutpricesand productsfromcompetingsuppliersandcanaccessthisatzerocostinotherwords,there arefewtransactionscostsinvolvedinsearchingfortherequiredinformationaboutprices. 6. Noexternalitiesarisingfromproductionand/orconsumptionwhichlieoutsidethemarket. Therealworldofimperfectcompetition! Itisoftensaidthatperfectcompetitionisamarketstructurethatbelongstooldfashionedtextbooks andisnotworthyofstudy!Clearlytheassumptionsofpurecompetitiondonotholdinthevast
52
majorityofrealworldmarkets,forexample,somesuppliersmayexertcontrolovertheamountof goodsandservicessuppliedandexploittheirmonopolypower. Onthedemandside,someconsumersmayhavemonopsonypoweragainsttheirsuppliers becausetheypurchaseahighpercentageoftotaldemand.Thinkforexampleaboutthebuying powerwieldedbythemajorsupermarketswhenitcomestosourcingfoodanddrinkfromfood processingbusinessesandfarmers.TheCompetitionCommissionhasbeeninvolvedinlengthy anddetailedinvestigationsintothemarketpowerofthemajorsupermarkets. Inaddition,therearenearlyalwayssomebarrierstothecontestabilityofamarketandfarfrom beinghomogeneousmostmarketsarefullofheterogeneousproductsduetoproduct differentiationinotherwords,productsaremadedifferenttoattractseparategroupsof consumers. Consumershaveimperfectinformationandtheirpreferencesandchoicescanbeinfluencedby theeffectsofpersuasivemarketingandadvertising.Ineveryindustrywecanfindexamplesof asymmetricinformationwherethesellerknowsmoreaboutqualityofgoodthanbuyera frequentlyquotedexampleisthemarketforsecondhandcars!Therealworldisoneinwhich negativeandpositiveexternalitiesfrombothproductionandconsumptionarenumerousboth ofwhichcanleadtoadivergencebetweenprivateandsocialcostsandbenefits.Finallytheremay beimperfectcompetitioninrelatedmarketssuchasthemarketforkeyrawmaterials,labourand capitalgoods. Addingallofthesepointstogether,itseemsthatwecancomeclosetoaworldofperfect competitionbutinpracticetherearenearlyalwaysbarrierstopurecompetition.Thatsaidthereare examplesofmarketswhicharehighlycompetitiveandwhichdisplaymany,ifnotall,ofthe requirementsneededforperfectcompetition.Intheexamplebelowwelookattheglobalmarketfor currencies. Currencymarketstakingusclosertoperfectcompetition Theglobalforeignexchangemarketiswhereallbuyingandsellingofworldcurrencies takesplace.Thereis24hourtrading,5daysaweek. TradevolumeintheForexmarketisaround$3trillionperdayequivalenttotheannual GDPofacountrysuchasFrance!31%ofglobalcurrencytradingtakesplaceinLondon aloneaworldfinancialcentre. Welloverninetypercentoftradingincurrenciesisspeculativeratherthanthebuyingand sellingofcurrenciestoenablepeopleandfirmstoconductbusinesssuchasthefinancing ofinternationaltradeortravelingoverseas. Themainplayersinthecurrencymarketsareasfollows: Banksbothasmarketmakersdealingincurrenciesandalsoasendusersdemanding currencyfortheirownoperations.ThesebanksincludeinvestmentbankssuchasMerrill LynchandJPMorganandcommercialhighstreetbankssuchasBarclaysandLloyds TSB. Hedgefundsandotherinstitutions(e.g.fundsinvestedbyassetmanagers,pension funds). CentralBanks(includingoccasionalcurrencyinterventioninthemarketwhentheybuy andselltomanipulateanexchangerateinaparticulardirection). Corporations(whomayusethecurrencymarketfordefensivehedgingofexposuresto risksuchasvolatileoilandgasprices.)
53
Privateinvestorsandpeopleremittingmoneyearnedoverseastotheircountryoforigin/ marketspeculatorstradingincurrenciesfortheirowngain/touristsgoingonholidayand peopletravelingaroundtheworldonbusiness. Whydoesacurrencymarketcomeclosetoperfectcompetition? Homogenousoutput:The"goods"tradedintheforeignexchangemarketsare homogenousaUSdollarisadollarandaeuroisaeurowhethersomeoneistradingitin London,NewYorkorTokyo. Manybuyersandsellersmeetopenlytodetermineprices:Therearelargenumbersof buyersandsellerseachofthemajorbankshasaforeignexchangetradingfloorwhich helpsto"makethemarket".Indeedtherearesomanysellersoperatingaroundtheworld thatthecurrencyexchangesareopenforbusinesstwentyfourhoursaday.Nooneagent inthecurrencymarketcan,ontheirowninfluencepriceonapersistentbasisallareprice takers.AccordingtoForex_Broker.net"Theintensityandquantityofbuyersandsellers readyfordealsdoesn'tallowseparatebigparticipantstomovethemarketinjointeffortin theirowninterestsonalongtermbasis." Currencyvaluesaredeterminedsolelybymarketdemandandsupplyfactors. Highqualityrealtimeinformationandlowtransactionscosts:Mostbuyersorsellers arewellinformedwithaccesstorealtimemarketinformationandbackgroundresearch analysisonthefactorsdrivingthepricesofeachindividualcurrency.Technological progresshasmademoreinformationimmediatelyavailableatafractionofthecostofjusta fewyearsago.Thisisnottosaythatinformationischeapanannualsubscriptiontoa BloombergoraReutersnewsterminalwillcostseveralthousanddollars.Butthemarketis richwithinformationandtransactionscostsforeachbatchofcurrencyboughtandsoldhas comedown. Seekingthebestprice:Thebuyersandsellersinforeignexchangeonlydealwiththose whoofferthebestprices.Technologyallowsthemtofindthebestpricequickly. Whatarethelimitationsofcurrencytradingas anexampleofacompetitivemarket? Firstlythemarketcanbeinfluencedby officialinterventionviabuyingand sellingofcurrenciesbygovernmentsor centralbanksoperatingontheirbehalf. Thereisahugedebateabouttheactual impactofinterventionbypolicymakers inthecurrencymarkets. Secondlytherearehighfixedcosts involvedinabankorotherfinancial institutionwhenestablishinganew tradingplatformforcurrencies.They needthecapitalequipmenttotradeeffectivelytheskilledlabourtoemployascurrency tradersandresearchers.Someofthesecostsmaybecountedassunkcostshardto recoverifadecisionismadetoleavethemarket. Despitetheselimitations,theforeigncurrencymarketstakeusreasonablyclosetoaworldof perfectcompetition.Muchthesamecanbesaidfortradingintheequitiesandbondmarketsand alsotheeverexpandingrangeoffuturemarketsforfinancialinvestmentsandinternationallytraded commodities.Otherexamplesofcompetitivemarketscanbefoundonalocalscaleforexample
54
alocalfarmersmarketwheretheremightbeasizeablenumberoffarmersofferingtheirproduce forsale. Theinternetandperfectcompetition Advancesininternettechnologyhavemadesomemarketsmorecompetitive.Ithascertainly reducedthebarrierstoentryforfirmswantingtocompetewithwellestablishedbusinessesfor examplespecialisttoyretailersarebetterabletobattleformarketsharewiththedominantretailers suchasToysRUsandWalMart. Oneofthemostimportantaspectsoftheinternetistheabilityofconsumerstofindinformation aboutpricesformanygoodsandservices.Thereareanenormousnumberofpricecomparison sitesintheUKcoveringeverythingfromdigitalcamerastopackageholidays,carinsurancetoCDs andjewellery. Thatsaidthepricecomparisonwebsitesthemselveshavecomeundercriticisminrecenttimes. Forexamplethesitesofferingtocomparehundredsofdifferentmotorinsurancepoliciesor mortgageproductsdrawinformationfromtheinsuranceandmortgagebrokersbutmightuse limitingassumptionsaboutthedifferenttypesofconsumerslookingforthebestpricetheresultis arangeofpricesfacingtheconsumerthatdontaccuratelyreflecttheirpreciseneedsand consumersmayonlyrealisethiswhen,forexample,theymakeaclaimonaninsurancepolicy boughtovertheinternetwhichturnsoutnottoprovidethespecificcovertheyneeded. Andinthemarketforpricecomparisonsitesthereismonopolypowertoo!Moneysupermarket.com currentlyhasaround40%oftheoverallcomparisonsitemarket,withConfused.comitsnearest rivalwithashareofabout10%. Priceandoutputintheshortrununderperfectcompetition
MarketDemandand Supply IndividualFirmsCostsand Revenues
MC(Supply) Market Supply
Price(P)
Price(P)
P1
P1
AR(Demand)=MR
AC AC1
Market Demand
Q1
Output(Q)
Q2
Output(Q)
Intheshortrun,theinteractionbetweendemandandsupplydeterminesthemarketclearing price.ApriceP1isestablishedandoutputQ1isproduced.Thispriceistakenbyeachfirm.The averagerevenuecurveistheirindividualdemandcurve. Sincethemarketpriceisconstantforeachunitsold,theARcurvealsobecomesthemarginal revenuecurve(MR)forafirminperfectcompetition.

55
Forthefirm,theprofitmaximisingoutputisatQ2whereMC=MR.Thisoutputgeneratesatotal revenue(P1xQ2).Sincetotalrevenueexceedstotalcost,thefirminourexampleismaking abnormal(economic)profits. Thisisnotnecessarilythecaseforallfirmsintheindustrysinceitdependsonthepositionoftheir shortruncostcurves.Somefirmsmaybeexperiencingsubnormalprofitsifaveragecostsexceed thepriceandtotalcostswillbegreaterthantotalrevenue. Shortrunlosses

MarketDemandand Supply IndividualFirmsCostsand Revenues
MC(Supply) Market Supply
Price(P)
Price(P)
P1
P1
AR=MR AC
AC2 P2 AR2(Demand)= MR2
MD1
MD2 Q1 IndustryOutput(Q) Q2 Output(Q)
Theadjustmenttothelongrunequilibriuminperfectcompetition Ifmostfirmsaremakingabnormalprofitsintheshortrun,thisencouragestheentryofnew firmsintotheindustry,whichwillcauseanoutwardshiftinmarketsupplyforcingdowntheruling price. Theincreaseinsupplywilleventuallyreducethepriceuntilprice=longrunaveragecost.Atthis point,eachfirmintheindustryismakingnormalprofit.Otherthingsremainingthesame,thereis nofurtherincentiveformovementoffirmsinandoutoftheindustryandalongrunequilibriumhas beenestablished.Thisisshowninthenextdiagram.
56
MarketDemandandSupply
Price(P) Price(P) MC(Supply) Market Supply (MS) P1 AC P2 AR2=MR2 Longrun equilibrium output AR1=MR1
IndividualFirmsCostsandRevenues
P1
MS2 P2 P2
Market Demand
Q1
Q2
Output(Q)
Q3
Output(Q)
Weareassuminginthediagramabovethattherehasbeennoshiftinmarketdemand.Theeffect ofincreasedsupplyistoforcedownthepriceandcauseanexpansionalongthemarketdemand curve.Butforeachsupplier,thepricetheytakeisnowloweranditisthisthatdrivesdownthe levelofprofitmadetowardsnormalprofitequilibrium. Inanexamquestionyoumaybeaskedtotraceandanalysewhatmighthappenif 1. Therewasachangeinmarketdemand(e.g.arisingfromchangesintherelativepricesof substituteproductsorcomplements.) 2. Therewasacostreducinginnovationaffectingallfirmsinthemarketoranexternal shockthatincreasesthevariablecostsofallproducers. AdamSmithonCompetition Thenaturalpriceorthepriceoffreecompetition...isthelowestwhichcanbetaken.[It]isthe lowestwhichthesellerscancommonlyaffordtotake,andatthesametimecontinuetheir business. Source:AdamSmith,theWealthofNations(1776),BookI,ChapterVII Thecommoncharacteristicsofmarketsthatareconsideredtobecompetitiveare: Lowerpricesbecauseofmanycompetingfirms.Suppliersfaceelasticdemandcurvesand anyriseinpricewillleadtoafallindemandandintotalrevenue.Thecrossprice elasticityofdemandforoneproductwillbehighsuggestingthatconsumersareprepared toswitchtheirdemandtothemostcompetitivelypricedproductsinthemarketplace. Lowbarrierstoentrytheentryofnewfirmsprovidescompetitionandensurespricesare keptlowinthelongrun. Lowertotalprofitsandprofitmarginsthaninmarketswhichdominatedbyafewfirms. GreaterentrepreneurialactivitytheAustrianschoolofeconomicsarguesthattrue competitionisaprocessratherthanastaticcondition.Forcompetitiontobeimprovedand sustainedthereneedstobeagenuinedesireonbehalfofentrepreneurstoengagein
57
competitivebehaviour,toinnovateandtoinventtodrivemarketsforwardandcreatewhat JosephSchumpeterfamouslycalledthegalesofcreativedestruction. Economicefficiencycompetitionwillensurethatfirmsattempttomovetowards productiveefficiency.Thethreatofcompetitionshouldleadtoafasterrateoftechnological diffusion,asfirmshavetobeparticularlyresponsivetothechangingneedsofconsumers. Thisisknownasdynamicefficiency. Theimportanceofnonpricecompetition Incompetitivemarkets,frequentlyitistheeffectivenessofnonpricecompetitionwhichiscrucial inwinningsalesandprotectingorenhancingmarketshare.Digestthisexamplefromthemarket forsandwiches! Perfectcompetitionandefficiency Perfectcompetitioncanbeusedasayardsticktocomparewithothermarketstructuresbecause itdisplayshighlevelsofeconomicefficiency. 1. Allocativeefficiency:Inboththeshortandlongrunwefindthatpriceisequaltomarginal cost(P=MC)andthusallocativeefficiencyisachieved.Attherulingprice,consumerand producersurplusaremaximised.Noonecanbemadebetteroffwithoutmakingsomeother agentatleastasworseoffi.e.weachieveaParetooptimumallocationofresources. 2. Productiveefficiency:Productiveefficiencyoccurswhentheequilibriumoutputis suppliedatminimumaveragecost.Thisisattainedinthelongrunequilibriumfora competitivemarket.Firmswithhighunitcostsmaynotbeabletojustifyremaininginthe industryasthemarketpriceisdrivendownbytheforcesofcompetition. 3. Dynamicefficiency:Weassumethataperfectlycompetitivemarketproduces homogeneousproductsinotherwords,thereislittlescopeforinnovationdesignedpurely tomakeproductsdifferentiatedfromeachotherandallowasuppliertodevelopandthen exploitacompetitiveadvantageinthemarkettoestablishsomemonopolypower. Someeconomistsclaimthatperfectcompetitionisnotagoodmarketstructureforhighlevelsof researchanddevelopmentspendingandtheresultingproductandprocessinnovations. Indeeditmaybethecasethatmonopolisticoroligopolisticmarketsaremoreeffectivelongtermin creatingtheenvironmentforresearchandinnovationtoflourish.Acostreducinginnovationfrom oneproducerwill,undertheassumptionofperfectinformation,beimmediatelyandwithoutcost transferredtoalloftheothersuppliers. Thatsaidahighlycontestablemarketprovidesthedisciplineonfirmstokeeptheircostsunder control,toseektominimisewastageofscarceresourcesandtorefrainfromexploitingthe consumerbysettinghighpricesandenjoyinghighprofitmargins.Inthissense,competitioncan stimulateimprovementsinbothstaticanddynamicefficiencyovertime.Itiscertainlyoneofthe mainthemesrunningthroughtherecenttougheningupofUKandEuropeancompetitionpolicyas thispassagefromarecentDTIanalysissuggests: Thelongrunofperfectcompetition,therefore,exhibitsoptimallevelsofeconomicefficiency.But forthistobeachievedalloftheconditionsofperfectcompetitionmustholdincludinginrelated markets.Whentheassumptionsaredropped,wemoveintoaworldofimperfectcompetitionwith allofthepotentialthatexistsforvariousformsofmarketfailure.
58
Costs Revenues P2 P1
Consumer Surplus(CS)
MC(Supply)
Marketequilibriumoutputwhere demand=supplyandwhereprice =marginalcostofproduction
Producer Surplus(PS)
AR(Demand)
NetLossofEconomic WelfarefrompriceP2 raisedabovemarginalcost
Q2
Q1
Output(Q)
Suggestionsforfurtherreadingonaspectsofcompetitivemarkets Consumersindangerofbeingmisledbypricecomparisonsites(Independent,October2007) Tescoaddstocontestabilityindigitaldownloads(Tutor2ublog,April2008)
59
11.
MonopolisticCompetition
Monopolisticcompetitionisaformofimperfectcompetitionandcanbefoundinmanyrealworld marketsrangingfromclustersofsandwichbarsandcoffeestoresinabusytowncentretopizza deliverybusinessesinacityorhairdressersinalocalarea.Smallscalenurseriesandcarehomes forolderpeoplemightalsofitintothemarketstructureknownasmonopolisticcompetition.

Priceand Cost P1 AC
MC
AC1
AR
MR
Q1
QuantityofOutput
Theassumptionsofmonopolisticcompetitionareasfollowsasyoucheckthroughthemlookto seethedifferencesbetweenthismarkstructureandperfectcompetition. 1. Therearemanyproducersandmanyconsumersinamarkettheconcentrationratiois low 2. Consumersperceivethattherearenonpricedifferencesamongthecompetitors'products i.e.thereisproductdifferentiation 3. Producershavesomecontroloverpricetheyarepricemakersratherthanprice takers.

60
4. Thebarrierstoentryandexitintoandoutofthemarketarelow Intheshortruntheprofitsmadebybusinessescompetinginthistypeofmarketstructurecanbeat anylevelinourexamplebelowthebusinessismakingsupernormalprofitsindicatedbythe shadedarea.Oneofthepredictionsofthemodelisthathighlevelsofabnormalprofitwillattract newsuppliersandnewproductsintothemarkettheeffectofwhichmightbetoreducethedemand forexistingproductsandreduceprofitsdowntowardsnormalprofitequilibrium. Strongbrandloyaltycanhavetheeffectofmakingdemandlesssensitivetoprice. Thelongrunequilibriummaybeasshowninourseconddiagramwithnormalprofitsbeing made.Therealityisthatastableequilibriumisneverreachednewproductscomeandgoallof thetime,somedobetterthanothers.Existingproductswithinamarketwilltypicallygothrougha productlifecyclewhichaffectsthevolumeandgrowthofsales.
Priceand Cost MC
AC
P2=AC2
AR MR Q2
QuantityofOutput
Oneofthepossibleimplicationsofmonopolisticcompetitionisthataninefficientoutcomeis reached.Pricesareabovemarginalcostandsaturationofthemarketmayleadtobusinesses beingunabletoexploitfullytheinternaleconomiesofscalecausingaveragecosttobehigher thanifthemarketwasbeingsuppliedbylessfirmsandproducts.Criticsofheavyspendingon marketingandadvertisingarguethatmuchofthisspendingiswastedandisaninefficientuseof scarceresources.Thedebateovertheenvironmentalimpactofpackagingislinkedstronglytothis aspectofmonopolisticcompetition.
61
CaseStudy:Competitioninthemarketfornurseryeducation Recently,oneleadingcompanyhastakenthedecisiontowithdrawfromthenurserymarket, whereasanotherhassetaclearstrategytoachievemarketleadershipthroughacquisitions.What liesbehindthedifferentapproaches? InAugust2007NordAngliadecidedtosellitsmarketleadingnurseryoperationforlessthanhalf thepriceitpaidtobuildthebusiness.NordAngliasoldits88kindergartenstoBusyBees,an Australianownedcompany,for31.2million.Itblamedovercapacityinthenurserymarketand thelackofeconomiesofscaleasthemainreasonsforthedisposal.In2006,NordAngliamadea lossof3.5milliononitsnurseryoperation,onturnoverof47.1million.ForBusyBees,the acquisitioncatapultedthebusinessintothenumberonepositioninthenurserymarket,givingita totalof134nurseriesacrosstheUK.JohnWoodward,theentrepreneurwhofoundedBusyBees withasinglesite25yearsagowantstomakeBusyBeesintoamajorchildcarebrand. TheUKnurserymarketiswortharound500millionandiscurrentlyhighlyfragmented,with some85%ofoperationsbeingmomandpopstyleindividualsites.Thetotalnumberofprivate nurseriesisaround15,000.Oneproblemfacingallnurseryoperatorsisthatthebusinessis labourintensive.Onememberofstaffisneededtolookaftereverythreebabiesorseven toddlers.Nurserystaffcostsarearound60%ofrevenue.Tobesustainable,anurseryhastobeat least60%fullineachofitstensessionsinaweek,althoughmanycustomerschoosenottousea nurseryforafullweek. Source:BusinessCaf,September2007
62
12.
TheModelofMonopoly
Whatdowemeanbymarketconcentration? Whenwefocusonindustrieswhereoneormorefirmshavesignificantmarketpowerweoftenuse thetermconcentrationratio.Thismeasuresthemarketshareofthetopnfirmsintheindustry. Sharecanbebysales,employmentoranyotherrelevantindicator.Thevalueofnisoftenfive,but maybethreeoranyothersmallnumber.Ifthetopnfirmsgainagreatermarketsharetheindustry issaidtohavebecomemorehighlyconcentrated.OurexamplebelowistakenfromtheJune2008 figuresformarketshareintheUKfoodretailsector. The3firmconcentrationratioismeasuredat63.9% The5firmconcentrationratioismeasuredat83.4% Thismarketstructuresuggestsanoligopolybuteachofthebusinesseshasmarket powerinthesensethateachhascontrolovertheproductsitsellsandthepricesit charges. Thedataisforthenationaleconomylocalandregionalconcentrationratiosmightbevery differentfromthatshowne.g.thelocalmonopolypowerenjoyedbyoneormore businesses.TheUKcompetitionauthoritiesareveryawareofthiswhentheyinvestigate markets. Tesco Asda(WalMart) Sainsburys Morrisons(Safeways) Cooperative(Somerfield) Waitrose Aldi Lidl Iceland MARKETSHARE (%) 31.2 16.8 15.9 11.4 8.1 3.9 2.9 2.3 1.7 CUMULATIVEMARKET SHARE (%) 31.2 48.0 63.9 75.3 83.4 87.3 90.2 92.5 94.2
1. Apuremonopolistinanindustryisasingleseller.Itisquiterareforafirmtohaveapure monopolyexceptwhentheindustryisstateownedandhasalegallyprotectedmonopoly. TheRoyalMailusedtohaveastatutorymonopolyondeliveringhouseholdmail.Butthis isnowchangingfastastheindustryhasbeenopeneduptofreshcompetition. 2. Aworkingmonopoly:Aworkingmonopolyisanyfirmwithgreaterthan25%ofthe industries'totalsales.Inpractice,therearemanymarketswherebusinessesenjoysome degreeofmonopolypowereveniftheydonothaveatwentyfivepercentmarketshare. Priceandoutputunderapuremonopoly Apuremonopolistisasinglesellerinanindustryinthiscase,thefirmistheindustryandit cantakemarketdemandasitsowndemandcurve.Thefirmisapricemakerbutamonopoly cannotchargeapricethattheconsumersinthemarketwillnotbear.Inthissense,theprice elasticityofthedemandcurveactsasaconstraintonthepricingpowerofthemonopolist.
63
Assumingthatthemonopolistaimstomaximiseprofits(whereMR=MC),weestablishashortrun priceandoutputequilibriumasshowninthediagrambelow.
Shortrunpriceandoutputunderapuremonopolytheaveragerevenuecurveisassumedto bethemarketdemandcurve.Apuremonopolyisasinglesellerofaproductinagiven market.Thefirmistheindustryandhasa100%marketshare
Revenue Costand Profit b P1 MC MonopolyProfit atPriceP1 AC
AC1
Monopolydemand (AR)=market demand MR Q1 Output(Q)
TheprofitmaximisinglevelofoutputisatQ1atapriceP1.Thiswillgeneratetotalrevenueequal toOP1aQ1,butthetotalcostwillbeOAC1aQ.Astotalrevenueexceedstotalcoststhefirmmakes abnormal(supernormal)profitsequaltoP1baAC1. Theeffectofariseincostsonmonopolypriceandprofits
64
AC2 Revenue Costand Profit MonopolyProfit atPriceP1 MonopolyProfit atPriceP2
MC2
AC1
P2 P1 AC2
MC1
AC1
Monopoly Demand(AR) MR Q2 Q1 Output(Q)
TheriseinpricefromP1toP2helpsthemonopolisttoabsorbsomeoftheriseincosts,butthenet effectisareductioninprofitsandacontractioninoutputfromQ1toQ2.Theextenttowhicha businesscanpassonariseincostsdependsonthepriceelasticityofdemandpricingpoweris greatestwhendemandispriceinelastic,i.e.consumersarenotpricesensitive.
65
13.
BarrierstoEntryandExitinMarkets
Barrierstoentryaredesignedtoblockpotentialentrantsfromenteringamarketprofitably. Theyseektoprotectthepowerofexistingfirmsandmaintainsupernormalprofitsand increaseproducersurplus.Thesebarriershavetheeffectofmakingamarketlesscontestable theyarealsoimportantbecausetheydeterminetheextenttowhichwellestablishedfirmscan priceabovemarginalandaveragecostinthelongrun. The1982NobelPrizewinningeconomistGeorgeStiglerdefinedanentrybarrierasAcostof producingwhichmustbebornebyafirmwhichseekstoenteranindustrybutisnotborneby businessesalreadyintheindustry. AnotherEconomist,GeorgeBaindefinedentrybarriersasTheextenttowhichestablishedfirms canelevatetheirsellingpricesaboveminimumaveragecostwithoutinducingpotentialentrantsto enteranindustry. TheBaininterpretationofentrybarriersemphasisestheasymmetryincoststhatoftenexists betweentheincumbentfirmandthepotentialentrant.Iftheexistingbusinesseshavemanagedto exploiteconomiesofscaleanddevelopedacostadvantageoverpotentialentrants,thismight beusedtocutpricesifandwhennewsuppliersenterthemarket.Thisisamoveawayfromshort runprofitmaximisationobjectivesbutitisdesignedtoinflictlossesonnewfirmsandprotecta dominantmarketpositioninthelongrun.Themonopolistmightthenrevertbacktoprofit maximizationonceanewentranthasbeensentpacking! Anotherwayofcategorisingentrybarriersis summarisedbelow o Structuralbarriers(alsoknownas innocententrybarriers)arisingfrom differencesinproductioncosts. o Strategicbarriers(seethenotesbelowon strategicentrydeterrence). o Statutorybarrierstheseareentry barriersgivenforceoflaw(e.g.patent protectionoffranchisessuchastheNational Lotteryortelevisionandradiobroadcastinglicences). Entrybarriersexistwhencostsarehigherforanentrantthanfortheincumbentfirms.Thisis showninthenextdiagram. TheincumbentmonopolisthasachievedeconomiesofscalesothatthatitsownLRACandLRMC arelowerthanthatofapotentialentrant.Ifthemonopolistmaintainsaprofitmaximisingpriceof P1,amarketentrantcouldachieveabovenormalprofitssinceitscostsarelowerthanthe prevailingprice.AtanypricebelowPethepotentialentrantwillmakealossandentrycanbe blockaded.
66
Revenue Costand Profit
A P1 D AC=MC(Potential Entrantintothemarket)
Pc
LRAC=LRMC(Existing Monopolist)
Monopoly Demand(AR) MR Q1 Qc Output(Q)
TheoryofEarlyMoverorFirstMoverAdvantage Sometimestherearesizeableadvantagestobeingfirstintoamarketfirstmoverscanestablish themselves,buildacustomerbaseandmakelifedifficultfornewfirmsonthescene.Thefirst moverideaissummarisedthus: Growfirst&becomelargerAchieveeconomiesofscaleBiggerbusinessgeneratesthe resourcestodomoreinnovationMoreinnovationleadstobetterproductsandlowercosts CatalysttogrowbiggerEventuallynoentrantcancompeteLaterentrantsmaybeforcedto exitthemarket BarrierstoExit(SunkCosts) Whilsttextbookstendtoconcentrateonthecostsofenteringamarket,oftenitisthefinancial implicationsofleavinganindustrythatactasoneofthemostimportantbarriershenceweneed toconsiderexitcosts.Agoodexampleoftheseisthepresenceofsunkcosts. Sunkcostscannotberecoveredifabusinessdecidestoleaveanindustry.Examplesinclude: o Capitalinputsthatarespecifictoanindustryandwhichhavelittleornoresalevalue. o Moneyspentonadvertising,marketingandresearchanddevelopmentprojectswhich cannotbecarriedforwardintoanothermarketorindustry. Whensunkcostsarehigh,amarketbecomeslesscontestable.Highsunkcostsactasabarrier toentryofnewfirmsbecausetheyriskmakinghugelossesiftheydecidetoleaveamarket.In contrast,marketssuchasfastfoodrestaurants,sandwichbars,hairdressingsalonsandlocal antiquesmarketshavelowsunkcostssothebarrierstoexitarelow. o Assetwriteoffse.g.theexpenseassociatedwithwritingoffitemsofplantand machinery,stocksandthegoodwillofabrand o Closurecostsincludingredundancycosts,contractcontingencieswithsuppliersandthe penaltycostsfromendingleasingarrangementsforproperty
67
o Thelossofbusinessreputationandgoodwilladecisiontoleaveamarketcan seriouslyaffectgoodwillamongpreviouscustomers,notleastthosewhohaveboughta productwhichisthenwithdrawnandforwhichreplacementpartsbecomedifficultor impossibletoobtain. o Amarketdownturnmaybeperceivedastemporaryandcouldbeovercomewhenthe economicorbusinesscycleturnsandconditionsbecomemorefavourable StrategicEntryDeterrence Strategicentrydeterrenceinvolvesanymovebyexistingfirmstoreinforcetheirpositionagainst otherfirmsofpotentialrivals.Thereareplentyofexamplesofthisincludingthefollowing: o Hostiletakeoversandacquisitionstakingastakeinarivalfirmorbuyingitup! o Productdifferentiationthroughbrandproliferation(i.e.investmentindevelopingnew productsandspendingonmarketingandadvertisingtoreinforceconsumer/brandloyalty). o Capacityexpansiontoachievelowerunitcostsfromexploitinginternaleconomiesof scale. o Predatorypricing:Predatorybehaviourisdefinedasadominantcompanysustaining lossesintheshortrunwiththeknowledgeitwillbeabletorecoupthemoncethe competitionisforcedtoexit,andisinbreachoftheCompetitionAct1998.Wereturntothis inthechapteronoligopolyandcartels. StrategicbarriersmaybedeemedanticompetitivebytheBritishandEUcompetition authoritiesTheEUCompetitionCommissionhasbeenactiveinrecentyearsinbuildingcases againstEuropeanbusinessesthathaveengagedinanticompetitivepracticesincludingprice fixingcartels. AllegationsofpredatorypricingintheCardiffbusmarket Cardiff'smainbuscompanyhasbeenaccusedof"predatorybehaviour"inaninvestigationbythe OfficeofFairTrading(OFT).TheOFTfoundthattheCardiffBusCompany,whichcarriesan estimated80,000peopleeachweekdayinCardiff,useditsdominantpositiontorunitsnofrills serviceswithrevenuessofarbelowcoststhatitwasimpossibleforitscompetitor(2Travelplc)to remaininthemarket.CardiffBusdeniedithadinfringedcompetitionlaw. Sources:NewsreportsandtheOfficeofFairTrading BordersvAmazon BordersbookstorehasbrokenawayfromAmazonaftersevenyearstolaunchitsownstandalone website.Borders.comwillhaveatotalof2millionbooksandDVDsinitsinventory.Inaddition,in anagreementwithAlibris,Borderswillnowofferabout60millionusedbooksforsale.Thesitealso featuresalinktoitscobrandedebookstorewithSonyandhastheabilitytodownloaddigitalaudio eitherinDRMorDRMfreeformats.ThesuccessorfailureoftheattemptbyBorderstobreakthe strangleholdofAmazoninthebattleformarketshareintheUKwillbeaninterestingtestcaseof thescaleofbarrierstoentryandthepoweroffirstmoveradvantage. Source:Tutor2ublog,June2008 Despitetheinevitabilityofentryandexitbarriersmarketsareconstantlyevolvingandweoftendo witnesstheentryofnewsuppliersevenwhenoneormorefirmshaveaclearpositionofmarket power.Entrycanoccurinavarietyofways: 1. Atakeoverfromoutsidetheindustry(sometimesknownastheTrojanhorserouteto bypassanystructuralentrybarriersthatmightexistwithinanindustry.)
68
2. Atransferofbrandnamesfromonesectoroftheeconomytoanother(forexample thediversificationpracticedbybothEasyGroup,VirginandStagecoachinrecentyears.) 3. Increasingcompetitionfromoverseasi.e.theliberalisationofmarketsaroundthe world CaseStudy:WaterACaseforCompetition? Since1989thenumberofwaterauthoritiesintheUKhasfallenfrom39to27asaresultof horizontalintegration.InadditiontotheconcernofmanytheownershipofUKwatercompanies hasincreasinglyfallenintoforeignownership.Mostcustomershavenochoiceaboutwho suppliesthemwithwaterandtheyaregenerallysuppliedwiththeirnearestwatercompany. TheWaterServicesRegulationAuthority(Ofwat)monitorsstandardsofservice(suchas leakagerepairandhowquicklycomplaintsaredealtwith)andalsothepriceschargedto customers.DuetothehugeamountofinvestmentrequiredtoimprovetheUKswater infrastructureandtomeetEuropeanUnionwaterqualitystandardspricestocustomershaverisen abovetherateofinflation(thusrisinginrealterms). Overtheyearsthegovernmenthasattemptedtoopenupthewaterindustrytocompetition enablingcustomerstochoosetheirsupplier.In2003,legislationwasintroducedseekingtoopen upthemarketbyallowingcustomersusingmorethan50millionlitresofwaterayeartochooseto switchsuppliersandthisthresholdmaybereducedintheyearsahead.Butformillionsof individualhouseholds,thereislittlechanceofeffectivecompetition. Anationalgridforwaterissomewayoffnotleastbecauseoftheexpenditureinvolvedin creatingone,butthewaterindustrycouldcopytheprincipleofcommoncarriagewhichenables competitiontooccurintheenergysector.Thiswouldmeanthatanewentranttothewatersupply marketwouldbeallowedaccesstothesupplynetworkbytheexistingmonopolyfirm.Withthehelp oftheregulatorentrybarrierstothewaterindustrycouldbeloweredandcompetitionintroduced. Thiswouldmakethemarketmorecontestablebuttheexistingfirmswouldmorethanlikelyhave hugeeconomiesofscaleadvantagesoveranynewentrant. Withclimatechangeaffectingwatersupply,thecontinuedproblemofleakingpipesanddebate overtheintroductionofhouseholdwatermeteringthefutureofthewaterindustrywillremainhigh onthepoliticalagenda. Source:RobertNutter,EconoMax,May2008 Suggestionsforfurtherreading: Watercompaniesarenotbeingencouragedtobeinnovativeandefficient(Telegraph,July2008)
69
14.
PriceDiscrimination
Mostbusinesseschargedifferentpricestodifferentgroupsofconsumersforthesamegoodor service!Thisispricediscrimination.Businessescouldmakemoremoneyiftheytreatedeveryone asindividualsandchargedthemthepricetheyarewillingtopay.Butdoingthisinvolvesacost theyhavetofindtherightpricingstrategyforeachpartofthemarkettheyservetheirrevenues shouldrise,butmarketingcostswillalsoincrease. Whatispricediscrimination? Pricediscriminationoryieldmanagementoccurswhenabusinesschargesadifferentpriceto differentgroupsofconsumersforthesamegoodorservice,forreasonsnotassociatedwith costs. Itisimportanttostressthatchargingdifferentpricesforsimilargoodsisnotpureprice discrimination. Wemustbecarefultodistinguishbetweenpricediscriminationandproductdifferentiation thelattergivesthesuppliergreatercontroloverpriceandthepotentialtochargeconsumersa premiumpricebecauseofactualorperceiveddifferencesinthequalityorperformanceofagood orservice. Conditionsnecessaryforpricediscriminationtowork Essentiallytherearetwomainconditionsrequiredfordiscriminatorypricing: o Differencesinpriceelasticityofdemand:Theremustbeadifferentpriceelasticityof demandforeachgroupofconsumers.Thefirmisthenabletochargeahigherpricetothe groupwithamorepriceinelasticdemandandalowerpricetothegroupwithamoreelastic demand.Byadoptingsuchastrategy,thefirmcanincreasetotalrevenueandprofits(i.e. achieveahigherlevelofproducersurplus).Toprofitmaximise,thefirmwillseektoset marginalrevenue=tomarginalcostineachseparate(segmented)market. o Barrierstopreventconsumersswitchingfromonesuppliertoanother:Thefirmmust beabletopreventmarketseepageorconsumerswitchingaprocesswhereby consumerswhohavepurchasedaproductatalowerpriceareabletoresellittothose consumerswhowouldhaveotherwisepaidtheexpensiveprice.Thiscanbedoneina numberofways,andisprobablyeasiertoachievewiththeprovisionofauniqueservice suchasahaircut,dentaltreatmentoraconsultationwithadoctorratherthanwiththe exchangeoftangiblegoodssuchasamealinarestaurant.Seepagemightbeprevented bysellingaproducttoconsumersatuniquemomentsintimeforexamplewiththeuseof airlineticketsforaspecificflightthatcannotberesoldunderanycircumstances. Examplesofpricediscrimination Pricediscrimination(TimHarfordcallsitpricetargeting)isacommontypeofpricingstrategy operatedbyvirtuallyeverybusinesswithsomepricingpower.Itisaclassicpartofcompetition betweenfirmsseekingamarketadvantageortoprotectanestablishedposition. (a)PerfectPriceDiscriminationorchargingwhateverthemarketwillbear Sometimesknownasoptimalpricing,withperfectpricediscrimination,thefirmseparatesthe marketintoeachindividualconsumerandchargesthemthepricetheyarewillingandabletopay. Ifsuccessful,thefirmcanextracttheentireconsumersurplusthatliesunderneaththedemand
70
curveandturnitintoextrarevenueorproducersurplus.Thisisimpossibletoachieveunlessthe firmknowseveryconsumersindividualpreferencesandwillingnesstopayand,asaresult,is unlikelytooccurintherealworld.Thetransactionscostsinvolvedinfindingoutthroughmarket researchwhateachbuyerispreparedtopayisthemainbarriertoabusinessesengaginginthis formofpricediscrimination. Ifthemonopolistisabletoperfectlysegmentthemarket,thentheaveragerevenuecurve becomesthemarginalrevenuecurveforthefirm.Themonopolistwillcontinuetosellextraunitsas longastheextrarevenueexceedsthemarginalcostofproduction. Inreality,mostsuppliersandconsumersprefertoworkwithpricelistsandmenusfromwhich tradecantakeplaceratherthanhavingtonegotiateapriceforeachunitofaproductboughtand sold. SecondDegreePriceDiscrimination Thistypeofpricediscriminationinvolvesbusinessessellingoffpackagesofaproductdeemedto besurpluscapacityatlowerpricesthanthepreviouslypublishedoradvertisedprice.Pricetends tofallasthequantityboughtincreases. Examplesofthiscanbefoundinthehotelindustrywherespareroomsaresoldonalastminute standbybasis.Inthesetypesofindustry,thefixedcostsofproductionarehigh.Atthesametime themarginalorvariablecostsaresmallandpredictable.Ifthereareunsoldrooms,itisoftenin thehotelsbestinteresttooffloadanysparecapacityatadiscountprices,providingthatthe cheaperpricethataddstorevenueatleastcoversthemarginalcostofeachunit. Thereisnearlyalwayssomesupplementaryprofittobemadefromthisstrategy.And,itcanalso beaneffectivewayofsecuringadditionalmarketsharewithinanoligopolyasthemain suppliersbattleformarketdominance.Firmsmaybequitehappytoacceptasmallerprofitmargin ifitmeansthattheymanagetostealanadvantageontheirrivalfirms. Theexpansionofecommercebybothwellestablishedbusinessesandnewentrantstoonline retailinghasseenafurthergrowthinseconddegreepricediscrimination. Earlybirddiscountsextracashflow CustomersbookingearlywithcarrierssuchasEasyJetorRyanAirwillnormallyfindlowerpricesif theyarepreparedtocommitthemselvestoaflightbybookingearly.Thisgivestheairlinethe advantageofknowinghowfulltheirflightsarelikelytobeandasourceofcashflowintheweeks andmonthspriortotheflighttakingoff.Closertothetimeofthescheduledservicethepricerises, onthejustificationthatconsumersdemandforaflightbecomesinelasticthenearertothetimeof theservice.Peoplewhobooklateoftenregardtraveltotheirintendeddestinationasanecessity andtheyarelikelytobewillingandabletopayamuchhigherprice. Theairlineshavebecomemastersatprice discriminationasameansofmaximisingrevenuefrom passengerstravellingontheflightnetworks.Other transportbusinessesdothesame!
71
PeakandOffPeakPricing Peakandoffpeakpricingandiscommoninthetelecommunicationsindustry,leisureretailingand inthetravelsector.Telephoneandelectricitycompaniesseparatemarketsbytime:Thereare threeratesfortelephonecalls:adaytimepeakrate,andanoffpeakeveningrateandacheaper weekendrate.Electricitysuppliersalsooffercheaperoffpeakelectricityduringthenight. Atoffpeaktimes,thereisplentyofsparecapacityandmarginalcostsofproductionarelow(the supplycurveiselastic)whereasatpeaktimeswhendemandishigh,weexpectthatshortrun supplybecomesrelativelyinelasticasthesupplierreachescapacityconstraints.Acombination ofhigherdemandandrisingcostsforcesuptheprofitmaximisingprice.
Price, Cost Supply(Marginal Cost)
P1
P2
PeakDemand OffPeak Demand MRPeak
MROffPeak
OutputOffPeak
OutputPeak
Output
ThirdDegree(MultiMarket)PriceDiscrimination Thisisthemostfrequentlyfoundformofpricediscriminationandinvolveschargingdifferentprices forthesameproductindifferentsegmentsofthemarket.Thekeyisthatthirddegree discriminationislinkeddirectlytoconsumerswillingnessandabilitytopayforagoodor service.Itmeansthatthepriceschargedmaybearlittleornorelationtothecostofproduction. Themarketisusuallyseparatedintwoways:bytimeorbygeography.Forexample,exporters maychargeahigherpriceinoverseasmarketsifdemandisestimatedtobemoreinelasticthanit isinhomemarkets.
72
MarketA Price MarketB
ProfitfromsellingtomarketA witharelativelyelasticdemand andchargingalowerprice
Price Pb
DemandinsegmentBofthe marketisrelativelyinelastic.A higherunitpriceischarged
Pa
MC=AC
MC=AC
ARa
MRa MRb Qa Quantity Qb ARb
MC=AC
Quantity
Supposethatafirmhasseparatedamarketbytimeintoapeakmarketwithinelasticdemand,and anoffpeakmarketwithelasticdemand.Thedemandandmarginalrevenuecurvesforthepeak marketandoffpeakmarketsarelabelledAandBrespectively.Thisisillustratedinthediagram above.Assumingaconstantmarginalcostforsupplyingtoeachgroupofconsumers,thefirmaims tochargeaprofitmaximisingpricetoeachgroup. InthepeakmarketthefirmwillproducewhereMRa=MCandchargepricePa,andintheoffpeak marketthefirmwillproducewhereMRb=MCandchargepricePb.Consumerswithaninelastic demandwillpayahigherprice(Pa)thanthosewithanelasticdemandwhowillbechargedPb. Theinternetandpricediscrimination Therapidexpansionofecommerceusingtheinternetisgivingmanufacturersunprecedented opportunitiestoexperimentwithdifferentformsofpricediscrimination.Consumersonthenetoften providesupplierswithahugeamountofinformationaboutthemselvesandtheirbuyinghabitsthat thengivesellersscopefordiscriminatorypricing.ForexampleDellComputerchargesdifferent pricesforthesamecomputeronitswebpages,dependingonwhetherthebuyerisastateorlocal government,orasmallbusiness. TwoPartPricingTariffs Anotherpricingpolicyistosetatwoparttariffforconsumers.Afixedfeeischargedandthena supplementaryvariablechargebasedonthenumberofunitsconsumed.Thereareplentyof examplesofthisincludingtaxifares,amusementparkentrancechargesandthefixedchargesset bytheutilities(gas,waterandelectricity).Pricediscriminationcancomefromvaryingthefixed chargetodifferentsegmentsofthemarketandinvaryingthechargesonmarginalunitsconsumed (e.g.discriminationbytime). Productlinepricing
73
Productlinepricingoccurswhentherearemanycloselyconnectedcomplementaryproducts thatconsumersmaybeenticedtobuy.Itisfrequentlyobservedthataproducermaymanufacture manyrelatedproducts.Theymaychoosetochargeonelowpriceforthecoreproduct(acceptinga lowermarkuporprofitoncost)asameansofattractingcustomerstothecomponents/ accessoriesthathaveamuchhighermarkuporprofitmargin. Goodexamplesincludemanufacturersofcars,cameras,razorsandgamesconsoles.Indeed discriminatorypricingtechniquesmaytaketheformofofferingthecoreproductasalossleader (i.e.pricedbelowaveragecost)toinduceconsumerstothenbuythecomplementaryproducts oncetheyhavebeencaptured.ConsiderthecostofcomputergamesconsolesorMach3Razors contrastedwiththepricesofthegamessoftwareandthereplacementblades! Weddingsandpricediscrimination Mentioningthatyouneedaroomoralocationforaweddingreception/partycanaddhundredsof poundstocharges.Peoplearepayingovertheoddsbecausethedemandforweddingservicesis priceinelastic.Brideandgroomwanteverythingtobeperfectontheirspecialdayandmany venueswillsimplyhikeupthechargeforthehireofaroomforaweddingbyseveralhundred pounds,oraphotographerwillraisefeesforanalldayevent.Whyshoulditcostsomuchmoreto hostalunchreceptionfollowingaweddingcomparedtoexactlythesameroom,mealfora corporatelunchorfuneralwake?Thisispricediscriminationatwork.TheaveragecostofaBritish weddingsettorisetonearly18,500.AndresearchfromhomeinsurerChurchillhasfoundthat Britishweddingguestsspend13.8billionattendingweddingseveryyear.Weddingscanbean expensivebusinessforallconcerned! Source:Newsreports Amazon'sUStextbookripoff AreUSstudentsbeingrippedoffbyAmazon.com?JonathanDingelatTradeDiversionblogpoints toaforthcomingpaperbyYale'sChristosCabolisandcolleagues,ATextbookExampleof InternationalPriceDiscrimination(PDF).Thepaperfindsthatalthoughbooksforgeneral audiencesaresimilarlypricedinternationally,"textbooksaresubstantiallymoreexpensiveinthe UnitedStates"(onamazon.com)thantheUK(amazon.co.uk).Theyarguethat"costfactorscannot explainthisphenomenonanddiscussseveraldemandsideexplanations." Source:AdaptedfromtheNewEconomistblog,October2006 ConsequencesofPriceDiscrimination Whogainsandwholosesoutfrompersistentandpervasivepricetargetingbybusinesses?To whatextentdoespricediscriminationhelptoachieveanefficientallocationofresources?There aremanyargumentsonbothsidesofthecoinindeedtheimpactofpricediscriminationon welfareseemsboundtobeambiguous.Wesummarisesomeoftheseargumentsbelow: Impactonconsumerwelfare Consumersurplusisreducedinmostcasesrepresentingalossofconsumerwelfare.Forthe majorityofbuyers,thepricechargediswellabovethemarginalcostofproduction.Those consumersinmarketsegmentswheredemandisinelasticwouldprobablypreferareturnto uniformpricingbyfirmswithmonopolypower! Howeversomeconsumerswhocannowbuytheproductatalowerpricemaybenefit.Previously theymayhavebeenexcludedfromconsumingit.Lowerincomeconsumersmaybepricedinto themarketifthesupplieriswillingandabletochargethemless.Goodexamplesmightinclude legalandmedicalserviceswherechargesaredependentonincomelevels.Greateraccessto theseservicesmayyieldexternalbenefits(positiveexternalities)whichthenhaveimplicationsfor
74
theoveralllevelofsocialwelfareandtheequitywithwhichscarceresourcesareallocated.Drugs companiesmightjustifysellingtheirproductsatinflatedpricesincountrieswhereincomesare higherbecausetheycanthensellthesamedrugstopatientsinpoorercountries. Producersurplusandtheuseofprofit Pricediscriminationisclearlyintheinterestsofbusinesseswhoachievehigherprofits.A discriminatingmonopolyisextractingconsumersurplusandturningitintosupernormalprofit. Ofcoursebusinessesmaynotbedrivensolelybytheaimofmaximisingprofit.Acompanywill maximiseitsrevenuesifitcanextractfromeachpersonthemaximumamountthatpersonis willingtopay. Pricediscriminationalsomightbeusedasapredatorypricingtactictoharmcompetitionatthe supplierslevelandincreaseafirmsmarketpower. Acounterargumenttothisisthatpricediscriminationmightbeawayofmakingamarketmore contestableinthelongrun.Forexample,thelowcostairlineshavebeenhugelysuccessfulpartly onthebackofextensiveuseofpricediscriminationamongconsumerstofilltheirplanes. Profitsmadeinonemarketmayallowfirmstocross subsidiselossmakingactivities/servicesthathave importantsocialbenefits.Forexamplemoneymade oncommuterrailorbusservicesmayallowtransport companiestosupportlossmakingruralornighttime services.Withouttheabilitytopricediscriminate,these servicesmayhavetobewithdrawnandjobsmight suffer. Inmanycases,aggressivepricediscriminationisseen asinimicaltobusinesssurvivalduringarecessionor suddenmarketdownturn. Anincreaseintotaloutputresultingfromsellingextra unitsatalowerpricemighthelpamonopolytoexploiteconomiesofscaletherebyreducinglong runaveragecosts. Sowhatdoyouthinkaboutpricediscrimination?Isitalegitimatetactictoincreaserevenueand profit?Ordoesitharmconsumerwelfaretoomuch?Onethingisforsure,itispervasive throughouteveryeconomyitisafactoflifeinmarketswherebusinesses,largeandsmall,have pricingpower. Suggestionsforfurtherreadingontheeconomicsofpricediscrimination Pricediscriminationisahighlycommontacticinallkindsofmarketshereisaselectionofarticles thatcovertheissue.Thekeyevaluationissueisthequestionofwhogainsandwho(ifanyone) losesfromsuchpricingstrategies.Andwhethergovernmentinterventionisjustified? CerealKillers(TimHarford,FinancialTimes,November2006) FairTradeorFoul(TimHarford,April2008) LonghaulflightsandpricediscriminationstrategyatRyanair(RigotnomicsBlog,June2008) PlentyofroomattheBeijingInn(Tutor2ublogJuly2008) Popcornandpricediscrimination(Tutor2ublog,February2008) PricediscriminationforBigMacs(Tutor2ublog,June2008)
75
PricediscriminationonPriceline(ThePricingBlog,May2008) Productsabotagehelpsconsumers(BBConline,TimHarford,August2007) Revisiononbusinesspricingstrategies(Tutor2uBlog,April2008) TimHarfordandtheSecretCappuccino(YouTube) YouTellUsWhatYourSeatIsWorth(NewYorkTimes,July2008)
76
15.
MonopolyandEconomicEfficiency
Inthissectionweevaluatethecostsandbenefitsofbusinesseswithindustrymuscleormonopoly pricingpowerinmarkets.Thestandardeconomicandsocialcaseagainstmonopolisticbusinesses isnolongerstraightforward.Marketsarechangingallofthetimeandsoaretheconditionsinwhich businessesmustoperateregardlessofwhethertheyhaveanynoticeablemarketpower. Whenacompanylowersitsprice,isthatgenuinecompetitionthatbenefitsconsumersoran attempttomonopolisethemarket?Ifacompanygainsmarketshare,isthataresultofimproved efficiencyormerelyacompetitivethreatinthelongrun?Whenacompanydevelopsinnovative productsthatcompetitorscannoteasilyduplicate,isthatmonopolization?Ifseveralcompanies looktolimitexcessoutputbecauseofdifficulttradingconditionsisthisnecessarilycollusive behaviourthatcompetitionpolicyshouldlooktostop? Theeconomiccaseagainstmonopoly Theconventionaltextbookargumentagainstmarketpoweristhatmonopolistscanearnabnormal (supernormal)profitsattheexpenseofefficiencyandthewelfareofconsumersandsociety. Themonopolypriceisassumedtobehigherthanbothmarginalandaveragecostsleadingtoa lossofallocativeefficiencyandafailureofthemarket.Themonopolistisextractingaprice fromconsumersthatisabovethecostofresourcesusedinmakingtheproductand,consumers needsandwantsarenotbeingsatisfied,astheproductisbeingunderconsumed. Thehigheraveragecostifthereareinefficienciesinproductionmeansthatthefirmisnotmaking optimumuseofscarceresources.Undertheseconditions,theremaybeacaseforsomeformof governmentinterventionforexamplethroughtherigorousapplicationofcompetitionpolicyorbya processofmarketderegulation(liberalisation).
CompetitiveMarket Price(P) Price(P) Market Supply Market Supply PureMonopoly
Pmon Pcomp
Market Demand MR Q1 Q2 Q1
Monopoly Demand
Output(Q)
XInefficienciesunderMonopoly
77
Thelackofgenuinecompetitionmaygiveamonopolistlessincentivetoinvestinnewideasor considerthewellbeingofconsumers.Itcanbearguedthatevenifthemonopolistbenefitsfrom economiesofscale,theyhavelittleincentivetocontroltheircostsand'X'inefficiencieswillmean thattherewillbenorealcostsavingscomparedtoacompetitivemarket. AdamSmithinAnInquiryintotheNature&CausesofWealthofNations(1776)"amonopolyis. Whenafirmisabletochargeexcessivepricesbydeliberatelykeepingitsmarketunderstocked. Acompetitiveindustrywillproduceinthelongrunwheremarketdemand=marketsupply. Considerthediagramsbelow.EquilibriumoutputandpriceisatQ1andPcomponthelefthand diagramandPcompandQ1ontherighthanddiagram.Atthispoint,Price=MCandtheindustry meetstheconditionsforallocativeefficiency. Iftheindustryisthentakenoverbyamonopolist(notnecessarilyimmediately!)theprofit maximisingpoint(MC=MR)isatpricePmonandoutputQ2.Themonopolistisabletochargea higherpricerestricttotaloutputandtherebyreducewelfarebecausetheriseinpricetoPmon reducesconsumersurplus.Someofthisreductioninwelfareisapuretransfertotheproducer throughhigherprofits,butsomeofthelossisnotreassignedtoanyotheragent.Thisisknownas thedeadweightwelfarelossorthesocialcostofmonopolyandisequaltotheareaABC.
Price(P) CompetitiveMarket Price(P) PureMonopoly
Market Supply
Market Supply
A Pmon Pcomp D C B
Netlossof consumersurplus Netlossof producersurplus
Market Demand Monopoly Demand MR Q1 Q2 Q1 Output(Q)
Asimilarresultisseeninthenextdiagramwhichmakestheassumptionofconstantlongrun averageandmarginalcostsunderbothcompetitionandmonopoly.Thedeadweightlossof welfareundermonopoly(whoseprofitmaximisingpriceisP1andQ1)isshownbythetriangle ABC.ThecompetitivepriceandoutputisPcandQcrespectively.
78
Revenue Costand Profit P1 A
MonopolyProfit atPriceP1 B Pc C LRAC=LRMC
Monopoly Demand(AR) MR Q1 Qc Output(Q)
PotentialBenefitsfromMonopoly Ahighmarketconcentration(fewnessofsellers)doesnotalwayssignaltheabsenceof competitionsometimesitcanreflectthesuccessofleadingfirmsinprovidingbetterquality products,moreefficiently,thantheirsmallerrivals Onedifficultyinassessingthewelfareconsequencesofmonopoly,duopolyoroligopolyliesin definingpreciselywhatamarketconstitutes!Innearlyeveryindustryamarketissegmentedinto differentproducts,andglobalizationmakesitdifficulttogaugethedegreeofmonopolypower. Sowhatarethemainadvantagesofamarketdominatedbyafewsellers? EconomiesofScale Amonopolistmightbebetterpositionedtoexploitincreasingreturnstoscaleleasingtoan equilibriumwhichgivesahigheroutputandalowerpricethanundercompetitiveconditions.Thisis illustratedinthenextdiagram,whereweassumethatthemonopolistisabletodrivemarginal costslowerinthelongrun,findinganequilibriumoutputofQ2andpricingbelowthecompetitive price.
79
CompetitiveMarket Price(P) Price(P) Market Supply Competitive Supply (MC) PureMonopoly
Pcomp Pmon
Monopoly Supplywith Scale Economies
Market Demand MR Q1 Q1 Q2
Monopoly Demand
Output(Q)
MonopolyProfits,ResearchandDevelopmentandDynamicEfficiency Asfirmsareabletoearnabnormalprofitsinthelongruntheremaybeafasterrateof technologicaldevelopmentthatwillreducecostsandproducebetterqualityitemsfor consumers. Monopolypowercanbegoodforinnovation.Despitethefactthatthemarketleadershipoffirms likeMicrosoftandSonyisoftencriticised,theirinvestmentsinresearchanddevelopment(R&D) canbebeneficialtosocietybecausetheyexpandthetechnologicalfrontierandopennewways toprosperity.Manyinnovationsaredevelopedbyfirmswithpatentsontheleadingedge technologies. BaumolOligopolyandInnovation WilliamBaumolaneconomistfromPrincetonUniversitypublishedabooktitledTheFreeMarket InnovationMachineinwhichheanalysedtheconditionsbestsuitedtoachieveafasterpaceof innovation.Baumolarguesthatthestructurethatfostersproductiveinnovationbestisoligopoly. TheBaumolhypothesisisthatoligopolistscompetebymakingtheirproductsdifferslightlyfrom theirrivals.Highlyinnovativefirmsareoftenquicktolicensenewtechnologyortobecome membersoftechnologysharingconsortia.(TheUKdigitalboom,BBCnews,August2007) NaturalMonopoly Thereareseveralinterpretationsofwhatanaturalmonopolyus 1. Itoccurswhenonelargebusinesscansupplytheentiremarketatalowerpricethantwoor moresmallerones 2. Anaturalmonopolyisasituationinwhichtherecannotbemorethanoneefficientprovider ofagood.Inthissituation,competitionmightactuallyincreasecostsandprices 3. Itisanindustrywheretheminimumefficientscaleisalargeshareoftotalmarketdemand suchthereisroomforonlyonefirmtofullyexploitalloftheavailableinternaleconomiesof scale 4. Anindustrywherethelongrunaveragecostcurvefallscontinuouslyasoutputexpands
80
Costs SRAC1
SRAC2
LRAC
LRMC
Output
Eachofthesedefinitionsislinked.Thekeypointisthatanaturalmonopolyischaracterizedby increasingreturnstoscaleatalllevelsofoutputthusthelongruncostperunit(LRAC)will driftlowerasproductionexpands.LRACisfallingbecauselongrunmarginalcostisbelowLRAC. Thiscanbeillustratedinthediagrambelow: AnaturalmonopolyoccursinanindustrywhereLRACfallsoveralargerangeofoutputlevels suchthattheremayberoomonlyforonesupplierontheirowntofullyexploitalloftheinternal economiesofscale,reachtheminimumefficientscaleandachieveproductiveefficiency. Becausethereisnosingledefinitionofanaturalmonopoly,noneoftheexamplesbelowarepurely nationalmonopoliesbutitissuggestedthattheircoststructuredoesstakethemclosetoa commonsenseinterpretation: 1. BritishTelecombuildingandmaintainingtheUKtelecommunicationsnetworkforthe broadbandindustryespeciallythefinalmilecopperwiringfromthelocalexchangesto eachhousehold 2. TheRoyalMailspostaldistributionnetworkcollection/sorting/delivery 3. VirginMediaowningandrunningthecabletelecommunicationsnetwork 4. CamelotoperatingthenationalnetworkfortheUKlottery 5. NationalRailowning,maintainingandleasingouttheUKrailnetwork 6. NationalGridplcwhichownsandoperatestheNationalGridhighvoltageelectricity transmissionnetworkinEnglandandWales.SinceApril1,2005italsooperatesthe electricitytransmissionnetworkinScotland.Ownsandoperatesthegastransmission network(fromterminalstodistributors). 7. LondonUnderground,TyneandWearMetro 8. NationalAirTrafficServices Animportantpointisthatanaturalmonopolydoesnotmeanthatthereisonlyonebusiness operatinginthemarketorthatonlyonefirmcansurviveinthelongrun.Indeedtheremaybemany smallerbusinessesoperatingprofitablyinsmallernichesegmentsofamarket(howeverthatis defined).
81
Possibleconflictsbetweenefficiencyandwelfare Itisoftensaidthatanaturalmonopolyraisesdifficultquestionsforcompetitionpolicybecause Ontheonehanditismoreproductivelyefficientfortheretobeonedominantprovider ofanationalinfrastructuree.g.arailnetworkorelectricitygeneratingsystem Naturalmonopoliesoftenrequireenormousinvestmentspendingtomaintainandimprove thenetworkse.g.whoisgoingtopayformakingourbroadbandnetworkfaster? Ontheotherhandbusinesseswithsuchdeeprootedmonopolypower(hugebarriersto entry)mightbetemptedtoexploitthatmarketpowerbyraisingpricesandmakinghuge supernormalprofitsdamagingconsumerwelfare Itiscertainlytruethattomakeprofits,anaturalmonopolistwillhavetopricewellabovethe marginalcostsofsupplywecanseethatinthenextdiagram. TheprofitmaximizingpriceisP1atanoutputofQ1.Priceiswellabovethemarginalcostof supplyandhighsupernormalprofitsaremadebutoutputishightooandthereisstillasizeable amountofconsumersurplusbecauseoftheinternaleconomiesofscalethathavebroughtdown theunitcostforallconsumers.(Weareignoringthepossibilityofpricediscriminationhere).
Costs SRAC1
SRAC2
P1 AR LRAC
C1
LRMC MR
Q1
Output
Optionsforcompetitionpolicyinindustriesthatresembleanaturalmonopoly 1. Nationalization:Bringingsomeoftheseindustriesintostateownership a. NetworkRailisanotforprofitbusiness(formerlyRailtrackplc)takenbackinto publicownershipin2001 b. NationalAirTrafficServicescurrentlyownedbytheUKgovernment(49%)The AirlineGroup(42%)whichisaconsortiumofBritishAirways,bmi,easyJet,Monarch Airlines,ThomasCookAirlines,ThomsonflyandVirginAtlanticBAA(4%)and NATSemployees(5%). 2. Pricecontrols
82
a. Formanyofthemajorutilities,thegovernmentintroducedindustryregulatorsto overseethesebusinesseswhentheywereprivatizedinthe1980sandearly1990s b. FormanyyearsutilitybusinessessuchasBritishTelecomandBritishGaswere subjecttopricecappingmostofthesehavenowfinishedalthoughsomeremain formoredetailsseethislink 3. Introducingcompetitionintotheindustrythishasbeenafavouredpolicy a. Basicallyinvolvesseparatingoutinfrastructurefromthefinalservicetothe consumerforexample: i. BritishTelecomwaseventuallyforcedtoopenuplocaltelecomexchanges andallowotherbusinessesintoinstallequipment(unbundlingthelocal loop)whothensellservicessuchasbroadbandtohouseholds competitorspayBTanaccesschargedesignedtogiveBTa10%rateof returnfromrunningthenetwork ii. NationalRailrunsthenetworkbuttrainoperatingcompanieshavetobid forthefranchisetorunpassengerservicesandtheindustryregulatorcan taketheirfranchiseawayifthequalityofserviceisntgoodenough iii. CamelothassuccessfullybidtooperatetheNationalLotteryuntil2017 CaseStudy:BAAsMonopolyTimetoHeadfortheDepartureGate Reviledbyairlinescomplainingofhighcharges andpoorserviceandlambastedbypassengers furiousaboutlostluggageandinterminable delays,thesummermonthshavebeen desperatefortheBritishAirportsAuthority(BBA) theownerandmanagerofHeathrow,Gatwick, Stansted,Glasgow,Edinburgh,Aberdeenand Southampton. Thesesevenairportsaccountfor90%oftheair passengersusingSouthEastandEastAnglian airportsand84%ofScottishairpassengers. BAArackeduprevenuesofover2bnin2007 andanoperatingprofitofcloseto400m. NearlyhalfofBAA'sincomecamefromaeronauticalchargesincludinglandingfeespaidby airlinesforeachflight.Overaquartercomesfromtheirretaildivisionandninepercentcomesfrom propertyincome.Onepercentofincomeflowsfromothertrafficchargesforexampleachargeof 4.48eachtimetheyusetheHeathrowTaxiSystem.Addintheprofitsfromexpensiveairportcar parking,profitsfromtheirstakeinHeathrowExpress,bureaudechangebusinessesanddutyfree, itisnothardtoseehowBAAisabletogeneratemonopolyprofits. Entertheairlines,manyofwhomhavecomplainedbitterlyaboutthequalityofserviceandthecost ofoperatingatBAA'sairports.BritishAirwaysclaimsthat"BAAsrecordatHeathrowhasbeen lamentableandcommonownershipistherootcauseofthefailuretoexpandHeathrowsrunway capacity.Ryanair,easilythemostoutspokenofallofthelowcostcarriersisreportedassaying that"Heathrowisamess,passengerscontinuetobestuckinlongsecurityqueuesatStansted andGatwicksdevelopmentisbeingheldbackbythisoverchargingmonopoly.Wecallonthe CompetitionCommissiontoforceabreakupofthisabusivemonopolyassoonaspossible. BAAhasmountedarobustdefenceofitspositionclaimingthat"commonownershiphasyielded benefitsforconsumersandremainsthebeststructurefortheefficientoperationofairportsthe mostimportantissueforpassengers.BAAarguesthatithasinvestedinmajornewfacilitiesand
83
thatthemajorproblemisthatUKairportterminalsarealreadyrunningatmaximumcapacity. GrupoFerrovial,theSpanishownersofBAAhasdefendedBAAasanaturalmonopolywiththe threemajorLondonairportstogethercompetingwithotherglobaltransporthubs. AsecondstrandofdefencefromBAAisthattheairportstheyrunnowhavebeenstarvedof investmentinthepastandthisaffectstheircurrentperformance.Theyclaimthatregulatorycontrol fromtheCivilAviationAuthority(CAA)isdamaging.BAAiscommittedtoinvestingmorethan 9.5bnupgradingthethreeairportsoverthenext10years.ButtheCAAisproposingtolowerthe caponinvestmentreturns,to6.2percentfrom7.75percent,adisincentivetogoaheadwithmulti billiondollarcapitalprojects? AcounterargumentisBAAhasaneffectiveratherthananaturalmonopolyandthatBAAgains morefromthespillovereffectsthatflowfrompassengerdemandexceedingthecapacityat Heathrow.AirlinesandtheirpassengersaremoreorlessforcedtoswitchtoGatwickand/or StanstedbecauseHeathrowiscompletelychocker!MonopolypowercanleadtoXinefficiencies, higherpricesandlowerlevelsofinnovation.Thepassengerexperiencedeterioratesbutthereis littlethattheycandoaboutit. InAugust2008,theCompetitionCommissionissuedareportarguingthatBAAmayhavetosell threeofitssevenUKairportsbecauseofconcernsaboutitsmarketdominance. Source:GeoffRiley,EconoMax,September2007 MPscallforBAAtobebrokenup(BBCnews,March2008) BAAtoraiseairportlandingfees(BBCnews,March2008) ThefutureofBritainsairports(BBCnews,August2008) Suggestionsforfurtherreadingonmonopolyandeconomicefficiencyandwelfare Inalloftheseexampleswearedealingwithbusinessesthathavesubstantialmarketpowereach industryneedstobejudgedonacasebycasebasishaveareadthroughsomeofthesearticles andconsiderwhethertherearegroundsforarguingthatmonopolypowerishavinganegative effectonconsumerwelfare. EUfinesMicrosoft680m'toclosedarkchapter'infightagainstmonopoly(Guardian,Feb2008) GavisconmakercheatedtheNHS(Newsnight,March2008) Glaxounveilsplanstodiversify(BBCnews,July2008) Havesupermarketsbecometoopowerful?(Independent,September2007) MEPdemandscityparkinginquiry(BBCnews,August2007) Mexicanpledgetotacklemonopolypower(FinancialTimes,May2008) MurdochversustheEveningStandardcompetitioninfreenewspapers(BBC,September2006) Openskiesdealcomesintoeffect(BBCnews,March2008) Payingformusicdownloadsislikebuyingair(TheTimes,July2008) ProbeintoBAAairportmonopoly(BBCNews,June2006) Supermarketsadmitmilkpricefix(BBCnews,December2007) Thechewinggumwar(BBCMoneyProgramme,May2007)
84
16.
CollusiveandNonCollusiveOligopoly
Whatisanoligopoly? Anoligopolyisamarketdominatedbyafew producers.Anoligopolyisanindustrywherethereisa highlevelofmarketconcentration.Examplesof marketsthatcanbedescribedasoligopoliesincludethe marketsforpetrolintheUK,softdrinksproducersand themajorhighstreetbanks.Anotherexampleisthe globalmarketforsportsfootwear60%ofwhichisheld byNikeandAdidas. However,oligopolyisbestdefinedbytheconduct(or behaviour)offirmswithinamarket. Theconcentrationratiomeasurestheextenttowhicha marketorindustryisdominatedbyafewleadingfirms. Normallyanoligopolyexistswhenthetopfivefirmsinthemarketaccountformorethan60%of totalmarketsales. Characteristicsofanoligopoly Thereisnosingletheoryofpriceandoutputunderconditionsofoligopoly.Ifapricewarbreaks out,oligopolistsmaychooseproduceandpricemuchasahighlycompetitiveindustrywould whereasatothertimestheyactlikeapuremonopoly. Anoligopolyusuallyexhibitsthefollowingfeatures: 1. Productbranding:Eachfirminthemarketissellingabrandedproduct. 2. Entrybarriers:Entrybarriersmaintainsupernormalprofitsforthedominantfirms.Itis possibleformanysmallerfirmstooperateontheperipheryofanoligopolisticmarket,but noneofthemislargeenoughtohaveanysignificanteffectonpricesandoutput 3. Interdependentdecisionmaking:Interdependencemeansthatfirmsmusttakeinto accountthelikelyreactionsoftheirrivalstoanychangeinprice,outputorformsofnon pricecompetition. 4. Nonpricecompetition:Nonpricecompetitionisaconsistentfeatureofthecompetitive strategiesofoligopolisticfirms. Duopoly Duopolyisaformofoligopoly.Initspurestformtwofirmscontrolallofthemarket,butinreality thetermduopolyisusedtodescribeanymarketwheretwofirmsdominatewithasignificant marketshare.TherearemanyexamplesofduopolyincludingCocaColaandPepsi(softdrinks), UnileverandProctor&Gamble(detergents),SothebysandChristies(auctioneersof antiques/paintings),StandardandPoorsandMoodys(creditratingagencies),BSkyBandSetanta (livePremiershipfootball),andAirbusandBoeing(aircraftmanufacturers).
85
Inthesemarketsentrybarriersarehighalthoughthereareusuallysmallerplayersinthemarket survivingsuccessfullysuchasVirginCola.However,ifithadnotbeenfortheEuropean CompetitionCommissionSkysmonopolyinthemarketforlivetelevisioncoverageofPremiership footballintheUKwouldhavecontinued.Thehighentrybarriersinduopoliesareusuallybasedon oneormoreofthefollowing:brandloyalty,productdifferentiationandhugeresearcheconomiesof scale. Source:AdaptedfromRobertNutter,EconoMax,October2007 KinkedDemandCurveModelofOligopoly

Costs Revenues RaisingpriceaboveP1 Demandisrelativelyelasticbecause otherfirmsdonotmatchapricerise Firmlosesmarketshareandsometotal revenue
AssumewestartoutatP1andQ1: Willafirmbenefitfromraisingprice aboveP1? Willitbenefitfromcuttingpricebelow P1?
P1 ReducingpricebelowP1 Demandisrelativelyinelastic Littlegaininmarketshareotherfirms havefollowedsuitincuttingprices Totalrevenuemaystillfall
AR Q1 Output(Q)
MR
Thekinkeddemandcurvemodelassumesthatabusinessmightfaceadualdemandcurveforits productbasedonthelikelyreactionsofotherfirmstoachangeinitspriceoranothervariable. Thecommonassumptionisthatfirmsinanoligopolyarelookingtoprotectandmaintaintheir marketshareandthatrivalfirmsareunlikelytomatchanotherspriceincreasebutmay matchapricefall.I.e.rivalfirmswithinanoligopolyreactasymmetricallytoachangeintheprice ofanotherfirm. Ifabusinessraisespriceandothersleavetheirpricesconstant,thenwecanexpectquitea largesubstitutioneffectmakingdemandrelativelypriceelastic.Thebusinesswould thenlosemarketshareandexpecttoseeafallinitstotalrevenue. Ifabusinessreducesitspricebutotherfirmsdecidetofollowsuit,therelativeprice changeissmalleranddemandwouldbeinelastic.Cuttingpriceswhendemandisinelastic alsoleadstoafallintotalrevenuewithlittleornoeffectonmarketshare. Thekinkeddemandcurvemodelmakesa predictionthatabusinessmightreacha stableprofitmaximisingequilibriumat priceP1andoutputQ1andhavelittle incentivetoalterprices.
86
Thekinkeddemandcurvemodelpredictstherewillbeperiodsofrelativepricestabilityunderan oligopolywithbusinessesfocusingonnonpricecompetitionasameansofreinforcingtheir marketpositionandincreasingtheirsupernormalprofits.Shortlivedpricewarsbetweenrivalfirms canstillhappenunderthekinkeddemandcurvemodel.Duringapricewar,firmsinthemarketare seekingtosnatchashorttermadvantageandwinoversomeextramarketshare. RecentexamplesofpricewarsincludethemajorUKsupermarkets,pricediscountingofcomputers inChinaandapricewarbetweencrosschannelspeedferryservices.Pricecompetitionis frequentlyseeninthetelecommunicationsindustry. Changesincostsusingthekinkeddemandcurveanalysis Onepredictionofthekinkeddemandcurvemodelisthatchangesinvariablecostsmightnotlead toariseorfallintheprofitmaximisingpriceandoutput.Thisisshowninthenextdiagramwhereit isassumedthatariseincostssuchasenergyandrawmaterialpricesleadstoanupwardshiftin themarginalcostcurvefromMC1toMC2.Despitethisshift,theequilibriumpriceandoutput remainsatQ1.ItwouldtakeanotherhikeincoststoMC3forthepricetoalter.
Price(P) MC3 MC2 MC1
Increaseinmarginalcostfrom MC2toMC3doesleadtoa changeinoutputandprice
P2 P1
Increaseinmarginalcost fromMC1toMC2doesnot leadtoachangeintheprofit maximisingpriceandoutput
AR
Q2
Q1 MR
Output(Q)
Thereislimitedrealworldevidenceforthekinkeddemandcurvemodel.Thetheorycanbe criticisedfornotexplainingwhyfirmsstartoutattheequilibriumpriceandquantity.Thatsaiditis onepossiblemodelofhowfirmsinanoligopolymightbehaveiftheyhavetoconsiderthelikely responsesoftheirrivals. Theimportanceofnonpricecompetitionunderoligopoly Nonpricecompetitionassumesincreased importanceinoligopolisticmarkets.Thisinvolves advertisingandmarketingstrategiestoincrease demandanddevelopbrandloyaltyamongconsumers. Businesseswilluseotherpoliciestoincreasemarket share:
87
o Betterqualityofserviceincludingguaranteeddeliverytimesforconsumersandlowcost servicingagreements. o Longeropeninghoursforretailers,24houronlinecustomersupport. o Discountsonproductupgradeswhentheybecomeavailableinthemarket. o Contractualrelationshipswithsuppliersforexamplethesystemoftiedhousesfor pubsandcontractualagreementswithfranchises(offeringexclusivedistribution agreements).Forexample,ApplehassignedexclusivedistributionagreementswithT MobileofGermany,OrangeinFranceandO2intheUKfortheiPhone.Theagreements giveApple10percentofsalesfromphonecallsanddatatransfersmadeoverthedevices. Advertisingspendingrunsinmillionsofpoundsformanyfirms.Somesimplyapplyaprofit maximisingruletotheirmarketingstrategies.Apromotionalcampaignisprofitableifthemarginal revenuefromanyextrasalesexceedsthecostoftheadvertisingcampaignandmarginalcostsof producinganincreaseinoutput.However,itisnotalwayseasytomeasureaccuratelythe incrementalsalesarisingfromaspecificadvertisingcampaign.Otherbusinessesseeadvertising simplyasawayofincreasingsalesrevenue.Ifpersuasiveadvertisingleadstoanoutwardshift indemand,consumersarewillingtopaymoreforeachunitconsumed.Thisincreasesthepotential consumersurplusthatabusinessmightextract. Relativelyhighspendingonmarketingisimportantfornewbusinessstartups(considerthehuge andoftenextravagantsumsspentonmarketingbytheemergingdotcomsduringtheinternet maniaofthelate1990sandinto2000)andalsobyfirmstryingtobreakintoanexistingmarket wherethereisconsumerorbrandloyaltytotheexistingproductsinthemarket. PriceCollusioninOligopoly Collusivebehaviouristhoughttobeacommonfeatureofmanyoligopolisticmarkets.Inthis sectionwelookatdifferentformsofcollusionstartingwithtacitcollusionbasedaroundprice leadership. Tacitcollusion Priceleadershipreferstoasituationwherepricesandpricechangesestablishedbyadominant firm,orafirmareusuallyacceptedbyothersandwhichotherfirmsintheindustryadoptand follow.Whenpriceleadershipisadoptedtofacilitatetacit(orsilent)collusion,thepriceleaderwill generallytendtosetapricehighenoughthattheleastcostefficientfirminthemarketmayearn somereturnabovethecompetitivelevel. Weseeexamplesofthiswiththemajormortgagelendersandpetrolretailerswheremany suppliersfollowthepricingstrategiesofleadingfirms.Ifmostfirmsinamarketaremovingprices inthesamedirection,itcantakesometimeforrelativepricedifferencestoemergewhichmight causeconsumerstoswitchtheirdemand. Firmswhomarkettoconsumersthattheyareneverknowinglyundersoldorwhoclaimtobe monitoringandmatchingthecheapestpriceinagivengeographicalareaareessentiallyengaged intacitcollusion.Doestheconsumerreallybenefitfromthis?TimHarfordsarticleMatchmeif youCaninFebruary2007isespeciallyworthreadingonthispricingstrategy. Tacitcollusionoccurswherefirmsundertakeactionsthatarelikelytominimiseacompetitive response,e.g.avoidingpricecuttingornotattackingeachothersmarket Itisoftenobservedthatwhenamarketisdominatedbyafewlargefirms,thereisalwaysthe potentialforbusinessestoseektoreduceuncertaintyandengageinsomeformofcollusive behaviour.Whenthishappenstheexistingfirmsengageinpricefixingcartels.Thisbehaviouris
88
deemedillegalbyUKandEuropeancompetitionlaw.Butitishardtoprovethatagroupoffirms havedeliberatelyjoinedtogethertoraiseprices. CaseStudy:TacitPriceCollusionintheUKEnergyMarket? TherehasbeenconcernforsometimethattheUKretailenergysectorhasbecomeconsolidated intodominancebyonlysixmajorcompaniesanoligopoly.Thesixcompanieswiththemajor marketsharesareBritishGas,ScottishandSouthernEnergy,EDF,E.ON,ScottishPowerand nPowerwhoalsoarethemembersoftheEnergyRetailAssociation(ERA).Themeetingsofthe ERAhavebeenseenbygroupssuchasEnergywatchasacartelwherepricesarefixedtoboost themembersprofits. IndustryinsidersbelievethattheERAmeetingshaveresultedinmembercompaniespricesofgas andelectricityrisinginstepwithinafewweeksofeachother.Afewlargecompaniessellinga homogeneousproductwhichispriceinelasticindemandhasallthemakingsofacartel.Thebig energysuppliershavebecomeincreasinglyverticallyintegratedinrecentyears,bothgenerating andretailinggasandelectricity. Theremaywellbenocartelbutratheracomplexmonopolyinwhichanoligopolymaynotactually colludebuttheoutcomeinthemarketsuggeststhattheyhave. Source:RobertNutter,EconoMax,October2007 ExplicitPriceFixing Collusionisoftenexplainedbyadesiretoachievejointprofitmaximisationwithinamarketor preventpriceandrevenueinstabilityinanindustry.Pricefixingrepresentsanattemptbysuppliers tocontrolsupplyandfixpriceatalevelclosetothelevelwewouldexpectfromamonopoly. Tocolludeonprice,producersmustbeabletoexertsomecontrolovermarketsupply.Inthe diagrambelowaproducercartelisassumedtofixthecartelpriceatpricePm.Thedistributionof thecarteloutputmaybeallocatedonthebasisofanoutputquotasystemoranotherprocessof negotiation. Althoughthecartelasawholeismaximisingprofits,theindividualfirmsoutputquotaisunlikelyto beattheirprofitmaximisingpoint.Foranyonefirm,expandingoutputandsellingatapricethat slightlyundercutsthecartelpricecanachieveextraprofits!Unfortunatelyifonefirmdoesthis,itis ineachfirmsintereststodoexactlythesameand,ifallfirmsbreakthetermsoftheircartel agreement,theresultwillbeexcesssupplyinthemarketandasharpfallintheprice.Underthese circumstances,acartelagreementcanbreakdown.
89
Price IndividualFirminsidetheCartel MC MC(industry) Pm(cartel) AC Pm(cartel) Price IndustryCostsandRevenues
Demand MR Quota FirmsOutput Industry Output(Qm) IndustryOutput
Collusioninamarketorindustryiseasiertoachievewhen: 1. Thereareonlyasmallnumberoffirmsintheindustryandbarrierstoentryprotectthe monopolypowerofexistingfirmsinthelongrun. 2. Marketdemandisnottoovariable(orcyclical)i.e.itisreasonablypredictableandnot subjecttoviolentfluctuationswhichmayleadtoexcessdemandorexcesssupply. 3. Demandisfairlyinelasticwithrespecttopricesothatahighercartelpriceincreasesthe totalrevenuetosuppliersthisiseasierwhentheproductisviewedasanecessity. 4. Eachfirmsoutputcanbeeasilymonitored(thisisimportant!)Thisenablesthecartel moreeasilytocontroltotalsupplyandidentifyfirmswhoarecheatingonoutputquotas. 5. Incompleteinformationaboutmotivationofotherfirmsmayinducetacitcollusion. Possiblebreakdownsofcartels Mostcartelarrangementsexperiencedifficultiesandtensionsandsomecartelscollapse completely.Severalfactorscancreateproblemswithinacollusiveagreementbetweensuppliers: 1. Enforcementproblems:Thecartelaimstorestrictproductiontomaximizetotalprofitsof members.Buteachindividualsellerfindsitprofitabletoexpandproduction.Itmaybecome difficultforthecarteltoenforceitsoutputquotasandtheremaybedisputesabouthowto shareouttheprofits.Otherfirmsnotmembersofthecartelmayopttotakeafreeride byproducingclosetobutjustunderthecartelprice. 2. Fallingmarketdemandcreatesexcesscapacityintheindustryandputspressureon individualfirmstodiscountpricestomaintaintheirrevenue.Therearegoodrecent examplesofthisincommoditymarketsincludingthecollapseofthecoffeeexportcartel. 3. Thesuccessfulentryofnoncartelfirmsintotheindustryunderminesacartelscontrol ofthemarkete.g.theemergenceofonlineretailersinthebookindustryinthemid1990s ledultimatelytotheendoftheNetBookAgreementin1995. 4. TheexposureofillegalpricefixingbymarketregulatorssuchasUKOfficeofFair Trading. ExposureofcartelswithintheEuropeanUnionandtheUSA
90
Inrecentyearsasubstantialnumberofpricefixingagreementshavebeenuncoveredbythe EuropeanUnion,UKandUSAcompetitionauthorities.Someofthemostprominentexamplescan beexploredbyusingthelinksbelow: Lawbrokenonpricingbytobaccofirms(2008) Airlinesfined$504minUSaircargopricefixingprobe(2008) BAgivenmassivefineforfuelsurchargepricefixing(2007) Howarchrivalscolludedtohikeupcostofairtravel(2007) Supermarketsfined116mfordairypricefixing(2007) Dutchbrewingcartel(2007) Liftmanufacturerscartel(2007) Rubbercartel(2007) Chemicalspricefixingcartel(2006) Copperpricefixingcartel(2006) Liftcompaniescartel(2005) Plasticsbagscartel(2005) Sothebysfined12mforpricefixing(2002)
MorerecentarticlesoncollusionareavailablefromtheTutor2ublog.
17.
OligopolyandGameTheory
Inbrief,gametheoryisaboutmakingpredictionsaboutanotherperson'sactions.Inthischapter weprovideanintroductiontogametheoryandconsidersomeareaswherelessonsfromgame theorycanbeappliedbyeconomistfromclimatechangenegotiationstotheincentivestoengage incrime! TheMontyHallproblem! Supposeyoureonagameshow,andyouregiventhechoiceofthreedoors.Behindonedoorisa car,behindtheothers,goats.Youpickadoor,saynumber1,andthehost,whoknowswhats behindthedoors,opensanotherdoor,saynumber3,whichhasagoat.Hesaystoyou,Doyou wanttopickdoornumber2?Isittoyouradvantagetoswitchyourchoiceofdoors? PossibleanswertotheMontyHallproblem GameTheory Gametheoryismainlyconcernedwithpredictingtheoutcomeofgamesofstrategyinwhichthe participants(forexampletwoormorebusinessescompetinginamarket)haveincomplete informationabouttheothers'intentions. Gametheoryanalysishasdirectrelevancetothestudyoftheconductandbehaviouroffirmsin oligopolisticmarketsforexamplethedecisionsthatfirmsmusttakeoverpricing,andhowmuch moneytoinvestinresearchanddevelopmentspending.Costlyresearchprojectsrepresentarisk foranybusinessbutifonefirminvestsinR&D,canarivalfirmdecidenottofollow?Theymight losethecompetitiveedgeinthemarketandsufferalongtermdeclineinmarketshareand profitability.ThedominantstrategyforbothfirmsisprobablytogoaheadwithR&Dspending.If theydonotandtheotherfirmdoes,thentheirprofitsfallandtheylosemarketshare.However, thereareonlyalimitednumberofpatentsavailabletobewonandifalloftheleadingfirmsina marketspendheavilyonR&D,thismayultimatelyyieldalowertotalrateofreturnthanifonlyone firmoptstoproceed. ThePrisonersDilemma
91
Theclassicexampleofgametheoryisthe PrisonersDilemma,asituationwheretwo prisonersarebeingquestionedovertheirguiltor innocenceofacrime.Theyhaveasimplechoice, eithertoconfesstothecrime(therebyimplicating theiraccomplice)andaccepttheconsequences,or todenyallinvolvementandhopethattheirpartner doeslikewise. Confessorkeepquiet?ThePrisonersDilemmais aclassicexampleofbasicgametheoryinaction! Thepayoffismeasuredintermsofyearsin prisonarisingfromtheirchoicesandthisissummarisedinthetablebelow.Nocommunicationis permittedbetweenthetwosuspectsinotherwords,eachmustmakeanindependentdecision, butclearlytheywilltakeintoaccountthelikelybehaviouroftheotherwhenunderinterrogation. WhenIamgettingreadytoreasonwithamanIspendonethirdofmytimethinkingaboutmyself andwhatIamgoingtosay,andtwothirdsthinkingabouthimandwhatheisgoingtosay. Source:AbrahamLincoln HereisanexampleofthePrisonersDilemma: Two prisoners are held in a separate room andcannotcommunicate Theyarebothsuspectedofacrime Theycaneitherconfessortheycandenythe crime Payoffs shown in the matrix are years in prisonfromtheirchosencourseofaction PrisonerB Confess Deny PrisonerA Confess (3years,3years) (10years,1year) Deny (1year,10years) (2years,2years)
Whatisthebeststrategyforeachprisoner?Equilibriumhappenswheneachplayertakes decisionswhichmaximisetheoutcomeforthemgiventheactionsoftheotherplayerinthegame. InourexampleofthePrisonersDilemma,thedominantstrategyforeachplayeristoconfess sincethisisacourseofactionlikelytominimisetheaveragenumberofyearstheymightexpectto remaininprison.Butifbothprisonerschoosetoconfess,theirpayoffi.e.3yearseachinprison ishigherthaniftheybothchoosetodenyanyinvolvementinthecrime. Thatsaid,evenifbothprisonerschosetodenythecrime(andindeedcouldcommunicatetoagree thiscourseofaction),theneachprisonerhasanincentivetocheatonanyagreementand confess,therebyreducingtheirownspellincustody. The equilibrium in the Prisoners Dilemma occurs when each player takes the best
PrisonerA
92
possible action for themselves given the actionoftheotherplayer. The dominant strategy is each prisoners uniquebeststrategyregardlessoftheother playersaction Beststrategy?Confess? A bad outcome! Both prisoners coulddo betterbybothdenying butoncecollusion sets in, each prisoner has an incentive to cheat! Confess PrisonerB Deny
Confess (3years,3years) (10years,1year)
Deny (1year,10years) (2years,2years)
93
ApplyingthePrisonersDilemmatobusinessdecisions Gametheoryexamplesusuallyrevolvearoundthepayoffsthatcomefrommakingdifferent decisions.Onearrangementofpossiblepayoffsisasfollows: Treferstothetemptationtodefect Rreferstotherewardformutualcooperationbetweenplayers Preferstothepunishmentformutualdefection Sreferstothesuckerspayoff Intheclassicprisonersdilemmatherewardtodefectingisgreaterthanmutualcooperationwhich itselfbringsahigherrewardthanmutualdefectionwhichitselfisbetterthanthesuckerspayoff. Andcritically,therewardfortwoplayerscooperatingwitheachotherishigherthantheaverage rewardfromdefectionandthesuckerspayoff. Considerthisexampleofasimplepricinggame:Thevaluesinthetablerefertotheprofitsthatflow frommakingaparticulardecision. FirmAsoutput Highoutput Lowoutput FirmBsoutput Highoutput 5m,5m 4m,12m Lowoutput 12m,4m 10m,10m
Displayofpayoffs:rowfirst,columnseconde.g.ifFirmAchoosesahighoutputandFirmBopts foralowoutput,FirmAwins12mandFirmBwins4m. Inthisgametherewardtobothfirmschoosingtolimitsupplyandtherebykeepthepricerelatively highisthattheyeachearn10m.Butchoosingtodefectfromthisstrategyandincreaseoutput cancauseariseinmarketsupply,lowerpricesandlowerprofits5meachifbothchoosetodo so. Adominantstrategyisastrategythatisbestirrespectiveoftheotherplayerschoice.Inthiscase thedominantstrategyiscompetitionbetweenthefirms. Gametheoryanalysishasdirectrelevancetoourstudyofthebehaviourofbusinessesin oligopolisticmarketsforexamplethedecisionsthatfirmsmusttakeoverpricingofproducts,and alsohowmuchmoneytoinvestinresearchanddevelopment.Costlyresearchprojectsrepresenta riskforanybusinessbutifonefirminvestsinR&D,cananotherrivalfirmdecidenottofollow? Theymightlosethecompetitiveedgeinthemarketandsufferadeclineinmarketshareand profitability. ThedominantstrategyforbothfirmsisprobablytogoaheadwithR&Dspending.However,there areonlyalimitednumberofpatentsavailabletobewonandifalloftheleadingfirmsinamarket spendheavilyonR&D,thismayultimatelyyieldalowertotalrateofreturnthanifonlyonefirm optstoproceed. ThePrisonersDilemmacanhelptoexplainthebreakdownofpricefixingagreementsbetween producerswhichcanleadtotheoutbreakofpricewarsamongsuppliers,thebreakdownofother jointventuresbetweenproducersandalsothecollapseoffreetradeagreementsbetween countrieswhenoneormorecountriesdecidesthatprotectioniststrategiesareintheirownbest interest. Thekeypointisthatgametheoryprovidesaninsightintotheinterdependentdecisionmaking thatliesattheheartoftheinteractionbetweenbusinessesinacompetitivemarket.
94
CaseStudy:ClaimsofPriceRiggingintheFoodIndustry Thereisplentyfortheconsumertofeel irkedaboutasthecostoffood,petroland otheressentialbasicsseemstorace aheadofthegeneralrateofinflation.Yet nowitseemsthereisaconspiracyamong somelargecompaniestofixthepriceof othergoodswebuy,suchastoothpaste andshampoo. ThereiscurrentlyanOFTinvestigationinto thepricingbehaviourofsomebigname companiesProctorandGamble,Coca Cola,KimberlyClark,GlaxoSmithKlineand Unilever.Theleadingsupermarkets Tesco,Sainsbury,AsdaandMorrisons havealsoreceivedvisitsbyOFT investigators.Whattheselargecompanies haveincommonisthateconomistswouldclassifythemasoligopolies(industrieswherethereare asmallnumberoflargefirms).Thesebusinessescanbehaveinthefollowingwaysaseconomic theorypredicts: Pricesarestickybyexpectingtheworst,firmsaremostlikelytochoosenonprice competition.Ifafirmisconsideringapricerise,theworstoutcomewouldbeiftheother firmsintheindustrydonotincreasetheirprices,causingthefirmtolosebusiness. Thereforethefirmwillbereluctanttoraiseprices.Ifafirmisconsideringreducingitsprice, theworstoutcomeisifalltheotherfirmsalsochoosetocutprices.Thefirmwillnotgain marketshare,butwillendupwithlessrevenue.Thereforethefirmwillbereluctantto decreaseitsprice,allotherthingsbeingequal.Sofirmswill,instead,usemethodsofnon pricecompetitionsuchasbuyone,getonefree,3for2offers,freegifts,loyaltypoints, etc.Firmsarelikelytospendlargeamountsonadvertisingdesignedtoestablishbrand loyalty. Pricewarssometimesanoligopolywillmakeanaggressivemovetotryandwinmarket share.Thebignamesupermarketsdothisfromtimetotime.Onefirmcutsprices significantlyandothersfolloworundercutsoasnottolosetheirshare.Thiscanbeagood outcomeforconsumers,butdoesnotappeartobehappeningatpresent. Collusionthisiswherethefirmschoosetoacttogethertofixpricesandcanbeillegal. However,somecollusivebehaviourishardtopindown,whichiswhyanOFTinvestigation isgoingahead.Ifcostsofproductionincrease,itisnotunreasonabletoexpectallfirmsin theindustrytorespondwithanincreaseinprice,butthereappearstobesomeevidence, forexample,thatsupermarketshaveusedrisingcostsasanexcusetoinflatetheirpricesto increaseprofitmargins. Ifitdoestranspirethatsomeofthebestknowncompanieshavebeenactingillegallybyprice fixing,thiswilllookverybadforthematatimewhenconsumersarealreadyfeelingthepinch. Source:LizVeal,EconoMax,June2008
95
CaseStudy:Prisoner'sDilemmaandClimateChangeNegotiations Canrepeatedgamesoftheprisonersdilemmahelp climatenegotiations? With2012signallingtheexpirydateoftheKyoto Protocol,thereisanurgentneedforasuccessor treatytotackletheeverincreasingglobalemissions problem.Themainissuewithtacklingclimatechange isthecosttocountriesofimplementingit.Tobe successfulitwillneedprofoundtransformationof energyandtransportorganisations,andchangesin thebehavioursofbillionsofconsumers.TheStern Reviewadmittedthatitwilllikelycost1%ofGDP eventhoughitdoesntseemmuch,itisdoublethe amountcurrentlyspentondevelopmentaid worldwide. TheUSAseesacaponcarbonemissionsasathreattocompetitiveness,andhencetoits globalsupremacy Thedevelopingworlddenouncesanycallsforacaponemissionsasaneffortbyformer colonialpowerstoholdbackdevelopment Europehasbeenmakingencouragingthoughpatchyprogresstowardstargets,driven mainlybyaoneoffswitchfromcoaltogas. Theissuehereishowcountriescanexpecttomakecutsinemissionswhentheireconomic competitorsrefuse.ThisinturnleadstotheTragedyoftheCommonswhichoccurswhena groupsindividualincentiveleadthemtotakeactionswhich,overall,leadtonegative consequencesforallgroupmembers. Acountrythatrefusestoact,whilsttheothercooperates,willexperienceafreeriderbenefit enjoyingtheadvantageoflimitedclimatechangewithoutthecost.Ontheflipside,anycountrythat imposeslimits,whenitscompetitorsdonot,incursnotjustthecostoflimitingitsownemissions, butalsoafurthercostintermsofreducedcompetitiveness Thedynamicsoftheprisonersdilemmadochangeifparticipantsknowthattheywillbeplayingthe gamemorethanonce.In1984anAmericanpoliticalscientistattheUniversityofMichigan,Robert Axelrod,arguedthatifyouplaythegamerepeatedlyyouarelikelytoseeemergingiscooperative ratherthandefectiveactions.Heidentifiedfourelementstoasuccessfulstrategywhichisthiscase canbeappliedtoclimatenegotiations: 1. BeNicesignuptounilateralcutsinemissions,asdeepasyoureconomyandfinancing capacityallows. 2. BeRetaliatorysingleoutcountriesthathavenotcommencedactionand,in collaboration,findwaysofpressurisingthemuntiltheydoso. 3. BeForgivingwhennoncompliantcountriescomeonboardgivethemgenerous applausesignalthatgoodbehaviourwillberewardedwithevendeepercutsinyourown emissions. 4. BeClearleteveryoneknowinadvanceexactlyhowyouaregoingtobehavethatyou willworkwiththemiftheytakeactiononemissions,andthatyouwillretaliateiftheydonot. RepeatedPrisonersDilemmaprovidesvaluableinsightintohowcountriesshouldactawayfrom thenegotiatingtableandoverthelongerterm.Ultimately,fortheplanetssake,onehopesthat everyonewillplaythegame
96
Source:MarkJohnston,EconoMax,December2007 JohnMaynardKeynesTheBeautyContest: ...professionalinvestmentmaybelikenedtothosenewspapercompetitionsinwhichthe competitorshavetopickoutthesixprettiestfacesfromahundredphotographs,theprizebeing awardedtothecompetitorwhosechoicemostnearlycorrespondstotheaveragepreferencesof thecompetitorsasawholesothateachcompetitorhastopick,notthosefaceswhichhehimself findsprettiest,butthosewhichhethinkslikeliesttocatchthefancyoftheothercompetitors,allof whomarelookingattheproblemfromthesamepointofview.Itisnotacaseofchoosingthose which,tothebestofonesjudgment,arereallytheprettiest,noreventhosewhichaverageopinion genuinelythinkstheprettiest. Wehavereachedthethirddegreewherewedevoteourintelligencestoanticipatingwhataverage opinionexpectstheaverageopiniontobe. Source:J.M.KeynesGeneralTheory,p.156,1936 Suggestionsforfurtherreadingongametheory Gametheoryresources(USbasedsite)www.gametheory.net/ Gametheorysociety(USbasedsite)www.gametheorysociety.org/ PrisonersDilemmaandaBigBrotherHousematesGame!http://www.paulspages.co.uk/hmd/ Doeconomistsneedbrains?(TheEconomist,July2008) Gameofcooperationandbetrayal GametheoryandtheDarkKnight(PurePedantryBlog,July2008) Gametheorycouldsavetheworld(Telegraph,July2008) Reapingrewardsforcheating(SydneyMorningHerald,July2008) Supermarketpetrolpricecuts(BBCnews,July2008) Underthehammerauctionsandgametheory(TimHarford,May2007) WorldCupGameTheory(TimHarford,Slate,July2006) Worldtradetalkscollapseovertariffprotection(Guardian,July2008) Suggestionsforfurtherreadingonoligopoly Calltoinvestigateenergy'oligopolies'(Guardian,May2008) CollapseoftheDOHAtradenegotiationsfreetradeversusprotectionism(BBCnews,July2008) Comfortablepoweroligopolyrippingoffcustomers(TheTimes,May2008) OPECcartelsemptytoolkit(FortuneMagazine,July2008) Tescopolywebsite Thaicartelideaoutragesriceconsumers(Times,May2008) TopParishotelsguiltyofpricefixing(Times,November2005) Wakeuptooldfashionedpowerofnewoligopolies(FinancialTimes,February2006)
97
18.
ContestableMarkets
Therehasbeenawealthofresearchand interestintheideaofmarketcontestabilityin recentyears,thischapterconsidersthenature ofacontestablemarket,thebarriersto competitionandhowcontestabilitycanaffectthe behaviourofbusinessesinthemarketplace. Whatisacontestablemarket? WilliamBaumoldefinedcontestablemarketsas existingwhere Anentranthasaccesstoallproductiontechniquesavailabletotheincumbents,isnotprohibited fromwooingtheincumbentscustomers,andentrydecisionscanbereversedwithoutcost. Foracontestablemarkettoexisttheremustbelowbarrierstoentryandexitsonewsuppliersto comeintoamarkettoprovidefreshcompetition.Foraperfectlycontestablemarket,entryintoand exitoutmustbecostless Therealityisthatnomarketisperfectlycontestablebutitisalsotruethatvirtuallyevery marketiscontestabletosomedegreeevenwhenitappearsthatthemonopolypositionofa dominantsellerisunassailable.Thiscanhaveimplicationsforthebehaviour(conduct)ofexisting firmsandthenaffectstheperformanceofamarketintermsofallocative,productiveand dynamicefficiency. Contestablemarketsandperfectcompetitionthedifferences Contestablemarketsaredifferentfromperfectcompetitivemarkets.Forexample,itisfeasibleina contestablemarketforonefirmtohavepricesettingpowerandforfirmsinamarkettoproduce adifferentiatedproduct. Therearethreemainconditionsforpuremarketcontestability: o Perfectinformationandtheabilityand/ortherightofallsupplierstomakeuseofthebest availableproductiontechnologyinthemarket. o Thefreedomtomarket/advertiseandenteramarketwithacompetingproduct. o Theabsenceofsunkcoststhisreducestherisksofcomingintoamarket. Sunkcostsabarriertocontestability Barrierstomarketcontestabilityexistwhentherearesunkcosts.Thesearecoststhathave beencommittedbyabusinesscannotberecoveredonceafirmhasenteredtheindustry.It mightbeeasiertothinkofsunkcostsascoststhatareunavoidableoncetheyhavebeen committedataparticularmomentintimeaclassicexamplebeingthemoneythatthetelecoms firmscommittedtowinningthe3rdgenerationmobilephonelicencesatauctionin2000. TheIncreasingContestabilityofMarkets OnefeatureoftheBritishandEuropeaneconomyinrecentyearshasbeenanincreaseinthe numberofmarketsandindustriesthataregenuinelycontestable.Severalfactorsexplainthis development: 1. EntrepreneurialZeal:Itisoftenthecasethatmarketsbecomemorecompetitivebecause ofthepersistenceofentrepreneurswhosimplydonotacceptthattheexistingmarket
98
structureisagiven.Anewsuppliermayhavetheadvantageofproductinnovationora morecompetitivebusinessmodelbasedondifferentpricingstrategies. 2. DeregulationofmarketsDeregulationinvolvestheopeningupofmarketsto competitionbyreducingsomeofthestatutorybarrierstoentrythatexist.Good examplesofrecentderegulationincludetheliberalisationoftelecommunicationsandpostal servicesaspartoftheEuropeanUnioncompetitioninitiatives.AndalsotheOpenSkies initiativeinaviationthatisaimedatopeninguptransAtlanticairtravel. 3. CompetitionPolicy:Toughercompetitionlawsactingagainstpredatorybehaviourby existingfirmsaredesignedtomakemarketsmorecontestable.InboththeUKandtheEU thishasincludedtougherrulesagainstpricefixingcartels.Whenmarketcontestabilityis weak,thereisnearlyalwaysgreaterscopeforcarteltypebehaviourbytheexistingfirms, particularlyifthemarketstructureinwhichtheyoperatecomesclosetoanoligopoly. 4. TheEuropeanSingleMarket:ThedevelopmentoftheSingleEuropeanMarkethas openedupthemarketsformembernations.Agoodexampleofthisishomeandcar insuranceandalsotheentryofWesternEuropeanclothesretailersontotheUKhigh streetsandshoppingmalls.Theabolitionofblockexemptionforcardealershipswithinthe EUshouldalsohelptomaketheretailcarmarketmorecontestableintheUKinparticular andmayhelptobringdownfurtherthepricesofnewcars. 5. TechnologicalChange(includingtheemergenceofecommerce):Theimpactofnew technologyishavingahugeeffect,notleastbecauseithavebroughtdownsomeofthe entrycostsinsomemarkets(leadingtoanincreaseincapitalmobility).Therapid expansionofecommerceforexamplehasleadtotheemergenceofnewplayersinthe travelsectorandonlinebookselling,insuranceandmanyothermarkets. 6. Technologicalspillovercanleadtothedevelopmentofrivalproductsthatcopyorimitate thecharacteristicsoftheproductsoftheincumbentfirms.Justafewyearsafterthelaunch ofViagra,theantiimpotencedrug,Levitra,thefirstmarketrivaltothehugelyprofitable Viagra,isnowbeingmanufacturedbytheGermanfirm,BayerAG,andmarketedbythe BritishfirmGlaxoSmithKline. CaseStudyTheGlobalCreditandDebitCardMarket Inthespringof2008VisafloatedontheUSstockmarketinan$18billioninitialpublicoffering,the largestintheUnitedStatesandfollowinghotontheheelsofthestock2006marketdebutfor VisasmainrivalMasterCard. Thetwobusinessesarelockedinafiercebattleformarketshare.CurrentlyVisahas55%ofthe worldspaymentscardsanda59%sliceoftotaltransactions.MasterCardhas36%ofcardsand 31%ofthevalueoftransactions.Simplemathstellsusthatthisisagoodexampleofaduopoly thereareotherplayersnotablyAmericanExpressandDinersClub,buttheyareinacompletely differentleague.Ifanything,VisaandMasterCardsmaincompetitorsarecashandcheques! Thekeytounderstandingthislevelofmarketdominanceistheconceptofaplatform(ornetwork) economyofscale.Thefixedcostsofbuilding,maintainingandexpandingapaymentssystemare enormousbutthemarginalcostsofaddingonemoreusertothesystemare,incontrast,tiny Overtheyears,Visahasbuiltalargeretailpaymentsnetworkwithcommercialrelationshipswith nearly17,000financialinstitutionsand30millionretailoutletsmakingiteasilytheworldsbiggest paymentssystem.Thereareover1.5billionVisacardsinissueandaround1billiontransactions aremadeannually.Visahasmorecardsincirculationthanallthemajorcompetitorscombinedand theircardsareacceptedin170countriesorterritories.InWesternEuropealone,nearly350million Visacardsarenowincirculation.11.4%ofconsumerspendingatpointofsaleinEuropeiswitha Visacard.AtChristmasin2007,theVisanetworkwashandling7,400messagespersecondand theirsystemhasacapacitytocopewithupwardsof12,000beforereachingaceiling.
99
TheVisabrandhasbeenextendedinmanydifferentwaystoexploiteconomiesofscopefrom basicATMcashcards,throughtodebitandcreditcardstargetedatdifferentsegmentsofthe paymentsmarket.TakeyourchoicefromVisaClassic,VisaGold,VisaPlatinum,VisaInfinite,Visa Electron,PLUSandVisaTravellersChequesandVPay! Becauseoftheinvestmentininfrastructureandtheinternaleconomiesofscalefromadding moremerchantoutletsandextracustomers,Visaestimatesthattheaveragecostpertransaction hasfallenbynearlyahalfoverthelastfiveyearsthisisahugelyimportantcompetitive advantageforthebusinessgoingforward OfcoursethishasnotstoppedregularaccusationsthatVisahasengagedinanticompetitive practicesasabarriertoentryinahighlyprofitableglobalindustry.In2007,AmericanExpress claimedthatVisaandothershadprevented20,000USbanksfromusingAmexcreditcard products.Earlierthisyear,AmericanExpressacceptedapaymentof1bnfromVisatosettlethe disputeandhaveVisadroppedasadefendantintheantitrustcase.OthercriticsofVisaand MasterCardclaimthatthehighchargesforusingcardsrepresentataxonconsumptionthathit thepooresthardest. AndthisyearaclusterofleadingEuropeanbanksincludingCommerzbank,DeutscheBank, SocitGnraleandBNPParibashasbeengivingseriousconsiderationtosettinguparival networktoVisaandMasterCard.Cantheyovercomethebarrierstoentryandmakeaprofitable entryintothismarket? Source:EconoMax,May2008 Howdoesthethreatofcompetitionaffectafirmsbehaviour? Howmightthecontestabilityofamarketaffecttheconductandperformanceofbusinesses?Itis worthemphasisinginessaysanddataquestionsthatitistheactualbehaviourofagentsinthe marketthatismoreimportantthatasimplepictureofmarketshare.
Costs Revenues
AC P1 MC
ProfitMaxat PriceP1
P2
AR(Monopoly)
MR Q1 Q2 Output(Q)
InthediagramaboveapuremonopolymightpriceatP1theprofitmaximisingequilibrium.Ifa marketiscontestable,thereisdownwardpressureonprice,becausethepresencesupernormal profitssignalsfornewfirmstoenterthemarketandiftheexistingmonopolistisproducingattoo highapriceorhasallowedtheiraveragetotalcoststodrifthigher,thenentrantscanundercutthe

100
monopolistandsomeoftheabnormalprofitwillbecompetedaway.Normalprofitequilibrium occurswhenaveragerevenueequalsaveragetotalcost(atoutputQ2andpriceP2).Alowerprice andhigheroutputcausesanincreaseinconsumersurplus. Whenmarketsarecontestableweexpecttoseelowerprofitmarginsthanwhenamonopoly operateswithoutcompetition.Indeedthethreatofcompetitionmaybejustaspowerfulan influenceonthebehaviouroftheexistingfirmsinamarketthantheactualentryofnew businesses.Ifadominantfirminacontestablemarketknowsthatnewsuppliersmaycomein thismaybesufficientforthemtochargeapriceclosertothelevelwemightexpectfroma competitivemarketstructure. Ifamarketiscontestable,industrystructureandfirmbehaviourisdeterminedbythethreatof competition'hitandrun'entry.Themarketwillresembleperfectcompetition,regardlessofthe numberoffirms,sinceincumbentsbehaveasiftherewereintensecompetition. MarketContestabilityinOnlineMusic iTuneshasovertakenWalmartasthebiggestretailerofmusicintheUnitedStates.Over50million peoplehaveusediTunessinceitsinceptionbutthemarketfordownloadablemusicisbecoming morecontestableasthemajorplayerslineupforashareofthesupernormalprofitsthatare available.MySpacehasenteredintoajointventurewithUniversal,SonyBMGandWarnerandwill nowcompetewithrivalssuchasLastFM(afreestreamingservice)eMusicandNapster. Accordingtothenewdata(whichcoversthemonthofJanuary)48percentofUSteenagersdidnt buyasingleCDin2007,comparedto38percentin2006.PaidmusicdownloadsintheUSA accountedforalmost30percentofallmusicsoldinJanuary. MusicsalesintheUSA(forJan2008): iTunesStore19percent WalMart15percent BestBuy13percent Amazon6percent Source:Tutor2ublog,April2008 Suggestionsforfurtherreadingoncontestablemarkets Busderegulationisnotworking(BBCnews,October2006) HDDVDdefeathitsToshibaprofit(BBCnews,March2008) Lasertreatmentderegulationfear(BBCnews,February2008) Londontailorsfacelowcostrival(BBCnews,March2008) QuestionmarksoverthefutureofDigitalRadio(Tutor2ublog,February2008) RenaultNissanjoinstheracetoproducea$2500car(Tutor2ublog,May2008) SonyindangeroflosinggamecrowntoNintendo(TheTimes,July2008) Tescoaddstocontestabilityindigitaldownloads(Tutor2ublog,April2008) Consolemakersinthreewayshootout(Independent,October2008) Googleandmarketcontestability EmperorforlifeGoogleandthesearchenginemarket(FinancialTimes,May2008) NewbiesonGoogleshorizon(Tutor2ublog,June2008) SearchsiteaimstorivalGoogle(BBCnews,July2008) Contestabilityintheairlineindustry Aneweraforairtravel(Tutor2ublog,March2008)
101
OpenSkiesdealcomesintoeffect(BBCnews,March2008) Transatlanticpricewar(BBCnews,February2008)
19.
MonopsonyPowerinProductMarkets
Monopsonyisanimportantideaineconomicsbutnotoftendiscussedinthemediaindeedthere wereonlysixreferencestoitintheFinancialTimesbetween2003and2008!Butforeconomists wantingtounderstandchangesinthebalanceofpowerbetweenbuyersandsellersindifferent marketsandhowthisaffectsprices,profitmarginsandincentives,itisimportanttohavean understandingofmonopsonyanditseffects.AtA2levelyouwillnotbeexpectedtousediagrams toshowtheimpactofmonopsonypowerinproductmarkets. Whatismonopsonypower? Amonopsonisthasbuyingpowerintheirmarket.Thisbuyingpowermeansthatamonopsonist canexploittheirbargainingpowerwithasuppliertonegotiatelowerprices.Thereducedcostsof purchasinginputsincreasestheirpotentialprofitmargins.Monopsonyexistsinbothproductand labourmarketsinthischapterwefocusonbuyingpowerinthemarketsforgoodsandservices. Examplesofindustrieswheremonopsonypowerexistsandpersists: 1. Theabilityoftheelectricitygeneratorstonegotiatelowerpriceswhennegotiatingcoaland gassupplycontracts 2. Themajorfoodretailershavepowerwhenpurchasingsuppliesfrommeatandpoultry farmers,milkproducers,winegrowersandothersuppliers.Giventhatthefourmajor supermarketsnowdominatetheindustry(namelyTesco,Sainsbury,WalMartAsdaand CooperativeSomerfield)Itmightbemoreaccuratetodescribethemashaving oligopsonypowerwhenitcomestopurchasingproductsfrombusinessesatearlier stagesofthesupplychain. 3. Acarrentalfirmseekingacontracttoacarmanufacturertosupplythousandsofnewcars fortheirfleet 4. Lowcostairlinesreapingthebenefitsofmonopsonypowerwhenpurchasinganewfleetof aircraft 5. BritishSugarbuysalmosttheentiresugarbeetcropproducedintheUKyear 6. Amazonsbuyingpowerintheretailbookmarketitgetsabetterpricethanother booksellersandthisgivesitasignificantcompetitiveadvantage. 7. TheincreasingbuyingpowerofcountriesforexampleChinainsecuringdealstobuy mineraldepositsfromothercountriesofteninlessdevelopednationsinAfrica. 8. Thegovernmentisamajorbuyere.g.inmilitaryprocurementandmightbeabletouse thisbargainingpowerwhenconfirmingcontractsfornewmilitaryequipmentandsupplies. CaseStudiesonMonopsonyPower Dividingthespoilsinthemilkindustry Supermarketsusetheirgiganticsizeandbargainingpowertocapturealmostalloftheprofitfrom themilkindustry,leavingfarmerswithatinyproportionofthetotal:equaltoonlyhalfapencefor eachlitreofmilk.ThatisthecentralfindingofnewresearchbyDrsHowardSmithandJohn
102
ThanassoulispresentedattheRoyalEconomicSocietys2008annualconference.Farmersarein theweakestposition,onlyabletosecure0.5penceperlitre,orabout3%ofthetotalsupplychain profitsfromliquidmilk. Theresearchsuggeststhatdairyfarmersmighthelptocounterbalancethepowerofthe supermarketsbystrengtheningfarmerscooperatives.Thisisalreadyhappeninginmanypartsof thecountry.Butfundamentallytheretailerswillalwaysholdthewhiphandinpricingnegotiations andcontractagreements.Thedangeristhatthemarketfailureduetoexcessivemonopsony powerwillleadtomanymoremilkfarmersleavingtheindustry,therebyincreasingthedemandfor importedmilk. IsthebuyingpowerofdairiessuchasRobertWisemanandDairyCrest,whothensellmuchof theirprocessedmilktolargesupermarketssuchasTescoandAsda,resultinginafairdealforthe smallscaledairyfarmerthepricetaker?Whenamarkethasasolebuyer,amonopsony,prices aredepressedbythebuyingpoweroftheonlyoutletfortheproducers.Arguablythedairyfarmer haslostouttothecombinedbuyingpowerofthedairiesandthesupermarkets. Source:Tutor2uEconomicsBlog,March2008andRobertNutter,EconoMax,November2006 Halfordsandtheirrelationshipswithsuppliers Inlate2005allegationsofabuseofbuyingpowerweredirectedattheUKbikeandcaraccessory retailerHalfords.Halfords,withover400retailoutlets,aretwelvetimeslargerthantheirnearest rivalandthussuppliersrelystronglyontheircustom.InDecember2005itwasreportedinthe financialpressthatHalfordswerechangingthetermsoftheiragreementswithsuppliers.In particularHalfordsallegedlytoldtheirsuppliersthatthatwouldbepaidin120daysnot90daysas hadbeenthepracticesince2003,beforewhichitwas30days.Halfordswouldbenefitbyanextra 53.2millionalmosttwicethecapitalspendingbythefirmfortheperiod.InadditionHalfords allegedlydemandeda5%acrosstherangecutinpricesandabiggercontributiontothe companysadvertisingspendbysuppliers.ThekeyissueiswhetherHalfordsactionsrestrict, distortorpreventcompetition.Hasthebalanceofpowerinthemarketshiftedtoomuchinfavourof thebuyercausinganunfairfallinpricesandprofitsforsellers? Source:RobertNutter,EconoMax,February2006 Monopsonypowerisoftengivenabadpress!Wereadofgreedysupermarketsabusingtheir buyingpowertoforcedownprofitmarginsforsuppliersandenjoyhigherreturnsforthemselves.In evaluationitisimportanttoremembersomeofthepossibleadvantagesfrommonopsonypower: 1. ImprovedvalueformoneyforexampletheUKnationalhealthservicecanuseits bargainingpowertodrivedownthepricesofroutinedrugsusedinNHStreatmentsand ultimatelythismeansthatcostsavingsallowformoretreatmentswithintheNHSbudget 2. Producersurplushasavalueaswellasconsumersurpluslowerinputcostswillraise profitabilitywhichmightbeusedtofundcapitalinvestmentandresearch 3. Amonopsonistcanactasausefulcounterweighttothesellingpowerofamonopolist 4. Inmostsupplychainrelationshipsforexamplebetweensupermarketsandtheirsuppliers thelongtermsustainabilityofanindustryrequiresthatbothbenefitifthereareno mutuallybeneficialgainsfromtrade,ultimatelytradeandexchangewillbreakdown. 5. ThegrowthoftheFairTradelabelandorganisationisevidenceofhowpressurefrom consumerscanleadtoimprovedcontractsandpricesforfarmersindevelopingcountries. Suggestionsforfurtherreadingontheeconomicsofmonopsonypower BarackObamaandJohnMcCaingotowarwithBigPharma(TheTimes,July2008) Bookstoresclubbingtogethertobeatthebigboys(BBCnews,July2008)
103
MilkpricesreportsparkscallforfairtraderulesinUK(Walesonline,March2008) Supermarketpowerstobecurbed(BBCnews,February2008) TateandLylesugartobeFairTrade(BBCnews,February2008) Tescotopaydairyfarmersmore(BBCnews,April2007)
20.
ConsumerandProducerSurplus
Consumerandproducersurplusexplained Consumersurplusisthedifferencebetweenthetotalamountthatconsumersarewilling andabletopayforagoodorservice(indicatedbythedemandcurve)andthetotalamount thattheyactuallypay(themarketprice). Producersurplusisthedifferencebetweenwhatproducersarewillingandabletosupply agoodforandthepricetheyactuallyreceive.Thelevelofproducersurplusisshownbythe areaabovethesupplycurveandbelowthemarketprice.

Price Supply
Consumer Surplus P1 ProducerSurplus
EquilibriumPoint
Demand
Q1
Quantity
Economicefficiency Economicefficiencyisachievedwhenanoutputofgoodsandservicesisproducedmakingthe mostefficientuseofourscarceresourcesandwhenthatoutputbestmeetstheneedsandwants andconsumersandispricedatapricethatfairlyreflectsthevalueofresourcesusedupin production. 1. Ifinaneconomy,noonecanbemadebetteroffwithoutmakingsomeoneelseworseoff, theconditionsforallocativeefficiencyhavebeenmet. 2. Ifinaneconomy,productionofgoodsandservicestakesplaceatminimumoffeasible averagecost,theconditionsforproductiveefficiencyhavebeenmet.

104
Allocativeefficiencyinacompetitivemarket Atthecompetitivemarketequilibriumpriceandoutput,wemaximiseconsumerandproducer surplus.Noonecanbemadebetteroffwithoutmakingsomeoneelseworseoffthisisknownas theconditionrequiredforaParetooptimalallocationofresources
Costs Revenues
Consumer Surplus(CS)
Supplyinacompetitivemarket
P2
Allocativeefficientprice andoutputatthemarket equilibrium Producer Surplus(PS) Requiresothermarketsto becompetitiveaswell!
P1
MarketDemand
NetLossofEconomic WelfarefrompriceP2raised abovetheequilibriumprice
Q2
Q1
Output(Q)
RadioheadPayingthepriceyouarewillingtopay Radiohead'snewalbumInRainbowswasreleasedtoawaveofpublicitylargelysurroundingtheir innovativepricingstrategy.Fanswereinvitedtonametheirownpriceforthedownloadablemp3 filesandintheevent,nearlytwothirdsofdownloaderspaidnothing.Indeedinternetmonitoring companyComscorefoundthatonly38%ofdownloaderswillinglypaidtodosoandtheaverage pricepaidforthealbumwas2.90.Onepersonintenwaswillingtopaybetween3.80and5.71 forthealbum. Source:Adaptedfromnewsreports Pricediscriminationandconsumer&producersurplus Pricediscriminationoccurswhenafirmchargesadifferentpricetodifferentgroupsofconsumers foranidenticalgoodorservice,forreasonsnotassociatedwiththecostsofsupply.Isprice discriminationsomethingthateconomistsshouldbesupportingintermsofthebehaviourof businessesandfinaloutcomesindifferentmarkets? Pure(1stdegree)discrimination With1stdegreepricediscriminationthefirmisabletoperfectlysegmentthemarketsothatthe consumersurplusisremovedandturnedintoproducersurplus.Thusthereisacleartransferof welfarefromconsumerstoproducers.Thisisshowninthenextdiagram.
105
Price(P)
P1 P2
P3 P4
Equilibriumoutputwithperfectprice discriminationthemonopolistwillsellan extraunitprovidingthatthenextunitadds asmuchtorevenueasitdoestocost
P5
AverageCost=MarginalCost
Consumersurplusisturnedinto extrarevenuefortheproducer =additionalproducersurplus (higherprofits)
MR Q1 Q2 Q3 Q4 Q5
AR(MarketDemand) QuantityofOutput(Q)
Thirddegree(ormultimarket)pricediscriminationinvolveschargingdifferentpricesforthesame productindifferentsegmentsofthemarket.Thekeyisthatthirddegreediscriminationislinked directlytoconsumerswillingnessandabilitytopayforagoodorservice.Itmeansthattheprices chargedmaybearlittleornorelationtothecostofproduction.Clearlytheelasticityofdemandis thekeyfactordeterminingthepricingdecisionforproducersforeachsegmentofthemarket.

Price MarketA Price ConsumersurplusatPricePa Pb MarketB ConsumersurplusatPricePa
Pa
ProfitfromsellingtomarketA witharelativelyelastic demandandcharginga lowerprice
DemandinsegmentBofthe marketisrelativelyinelastic.A higherunitpriceischarged
MC=AC
MC=AC
ARa
MRa MRb Qa Quantity Qb ARb Quantity
Themarketisusuallyseparatedintwoways:bytimeorbygeography.Forexample,exporters maychargeahigherpriceinoverseasmarketsifdemandisfoundtobemoreinelasticthanitisin
106
homemarkets.Thereismoreconsumersurplustobeexploitedwhendemandisinsensitiveto pricechanges.
21.
PriceTakersandPriceMakersPricingPower
Inthissummarychapterwedrawtogetherstrandsfrompreviouschaptersandconsiderthekey factorsthatinfluencetheabilityofbusinessestodeterminepricesastheycompeteinmarkets. Thefactorsthatdeterminethevarietyofpricingdecisionsopentoabusinessnearlyalwayscome backtotwomaindrivingforces o Themarketstructureinwhichabusinessoperates. o Theobjectivesthatabusinessmaybepursuingatagiventime. Fixingthepricedoesnotnecessarilyimplysomeanticompetitivetypeofbehaviour!Itrefersto thepowerthatafirmhastousesomediscretioninthepricesitchargestogroupsofconsumers foroneormoreproducts Mostbusinessesaremultiproductfirmsservicingavarietyofdifferentmarkets.Indeedmarkets canbecomehighlysegmentedeachwiththeirowncharacteristicssothefactorswillvaryfrom industrytoindustry. Keyfactorsaffectingthepricingpowerofabusiness (1)MarketStructure Perfectcompetition o Pricetakingfirmshavenoinfluenceovertherulingmarketprice. o Freeentryandexistofbusinessesinthelongrundrivesdownprofitstowardsnormal. o Eachsupplierproduceshomogeneousproductshencetheperfectlyelasticdemandcurve.
MarketDemandandSupply Price(P) Price(P) MC(Supply) Market Supply IndividualFirmsCostsandRevenues
P1
P1
AR(Demand)=MR
AC AC1
Market Demand
Q1
Output(Q)
Q2
Output(Q)
Puremonopoly
107
o Themonopolisthastheabilitytoearnsupernormalprofitsintheshortandthelongrun. o Theirmarketpositionmaybeprotectedthroughtheuseofentrybarriers. o Thereisthepotentialforfrequentuseofpricediscrimination.

Costs
ProfitatPriceP1 =(priceAC)xoutputQ1 Profitmargin=P1AC1

P1 MC SRAC
AC1
AR (Monopoly) MR Q1 Output(Q)
Oligopoly o Oligopolyiscompetitionamongthefew(withhighlikelihoodofafewdominantfirms). o Eachfirmhassomemarketpower,suppliesbrandedproductsandentrybarriersexist. o Keyfactoristheinterdependentnatureofpricingdecisionsbetweenrivalfirms. o Eachfirmmustconsiderstrategicbehaviourofotherplayersinthemarket. o Objectivemightbeprotectingmarketshareratherthanpureprofitmaximisation. Contestablemarkets o Contestablemarketsaremarketswheretheentryandexitcostsarelow. o Potentialforhitandrunentrytocreamoffprofitsifincumbentfirmsarebeinginefficient. o Thethreatofnewentryfromnewsuppliersornewproductsaffectsthecurrentbehaviourof existingfirms(mayforcethemtopricemorecompetitivelylessscopeformonopoly pricing). o Therearebarrierstocontestabilitythehigherthebarriers,thegreaterthepricingpowerin thehandsoftheincumbentfirmsbecausetheriskofhitandrunentryislower. (2)PriceandCrosspriceElasticityofDemand Elasticityofdemandremainsafundamentalfactoraffectingafirmspricingpower: o Whendemandisinelastic,abusinesscanraisepricewithoutlosingadisproportionatelevel ofsales. o Whendemandispriceelastic,thepotentialtoraisepriceandextractconsumersurplus, turningitintohigherproducersurplus/profitisreduced.
108
Crosspriceelasticityofdemandislinkedtothisi.e.thepercentagechangeindemandforgoodX resultingfromagivenpercentagechangeinthepriceofarelatedproduct(inparticulartherelative priceofasubstitute)

Costs
LowPriceElasticityofDemand
HighPriceElasticityofDemand
MC P1
SRAC
MC
SRAC
P1 AC1 AC1 AR (Monopoly)
MR MR Q1 AR (Monopoly) Q2 Output(Q)
Whenthecrosselasticityofdemandislow,thesubstitutioneffectfromchangesinrelative pricesisweakconsumersarelesslikelytoswitchtheirdemand,givingthefirmgreaterprice power. (3)Productdifferentiationmovingawayfromhomogeneousproducts o Someconsumerswillingtopaypremiumpricesfornewproducts(knownasearly adopters). o Productstowardstheendoftheirlifecyclemoreelasticdemand,lowerprices. o Impactofmarketingandadvertisingonconsumerloyalty/brandloyalty. (4)TheRegulatorySystem Governmentappointedregulatoryagenciesmayintervenedirectlyorindirectlyinthepricesetting process.Theregulatoryagenciescoverprivatisedutilitiessuchasgas,electricity, telecommunications,theairportsandtherailindustrymostoftheseregulatorshaveattimes enforcedpricecappingformulaelimitingtheextenttowhichtheutilitiescanincreasepricesyear onyear.Someoftheregulatorshavenowliftedpricecontrolsbecausetheybelievethatthereis nowsufficientcompetitioninthemarket(agoodexampleisthegasindustry.) (5)TheInternationalEnvironment Mostbusinessesfacecompetitioneitherfromdomesticrivalsorfrominternationalcompetitors. Increasinglythepricingdecisionsofonebusinessareinfluencedbythestrengthofcompetition fromoverseassuppliers.Globalisationhasmadethisakeyfactorinmanyindustries (6)TheEconomicCycle Thepricingpowerofabusiness(oragroupoffirmswithinamarket)isalsoaffectedby macroeconomicvariablesincludingthestrengthofdomesticandglobaldemandatdifferentstages oftheeconomiccycle.Whendemandisstrongandrising(e.g.duringtheupturnphaseofthe economiccycle),abusinesswillhavemorepricingpowerthanwhendemandismuchweaker
109
andfalling(e.g.duringarecession).Oftenamarketmaybeaffectedbyademandsideshock whichtakesawaythepricingpowerofsuppliers.Theairlineindustryinthewakeoftheterrorist attacksin2001couldbeconsideredasanexampleofthis. Summaryofthemainfactorsaffectingafirmspricingpower Category Costs InfluenceonPricingPolicy In order to make a profit, a business should ensure that its products are priced above theiraveragecost.Intheshortterm,itmaybeacceptabletopricebelow AC ifthis price exceedsmarginalcost sothatthesalestillproducesapositive contributiontofixedcosts. If the business is a monopolist, then it has pricesetting power. At the other extreme, if a firm operates under conditions of perfect competition, it has no choiceandmustacceptthemarketprice. The reality is usually somewhere in between. In such cases the chosen price needstobeconsideredrelativetothoseofclosecompetitorsandwithoneeyeto thelikelyreactionofrivalfirmswhenabusinesschangesitspricingstrategy. Consideration ofcustomerexpectationsaboutpricemustbeaddressed.Ideally, abusinessshouldattempttoquantifyitsdemandcurvetoestimatewhatvolume of sales will be achieved at given prices and also the price elasticity of demand whenpriceschange Possiblepricingobjectivesinclude: Tomaximiseprofitsortoachieveatargetreturnonacapitalinvestmentproject Toachieveatargetsalesfigureinagiventimeperiod Toachieveatargetmarketshare Tomatchthecompetition,ratherthanleadthemarket
Competitors
Customers
Business Objectives
SummaryonMarketStructures Marketstructureisbestdefinedastheorganisationalandothercharacteristicsofamarket.We focusonthosecharacteristicswhichaffectthenatureofcompetitionandpricingbutitis importantnottoplacetoomuchemphasissimplyonthemarketshareoftheexistingfirmsinan industry. Traditionally,themostimportantfeaturesofmarketstructureare: Thenumberoffirms(includingthescaleandextentofforeigncompetition) Themarketshareofthelargestfirms(measuredbytheconcentrationratioseebelow) Thenatureofcosts(includingthepotentialforfirmstoexploiteconomiesofscaleand alsothepresenceofsunkcostswhichaffectsmarketcontestabilityinthelongterm) Thedegreetowhichtheindustryisverticallyintegratedverticalintegrationexplains theprocessbywhichdifferentstagesinproductionanddistributionofaproductareunder theownershipandcontrolofasingleenterprise.Agoodexampleofverticalintegrationis theoilindustry,wherethemajoroilcompaniesowntherightstoextractfromoilfields,they runafleetoftankers,operaterefineriesandhavecontrolofsalesattheirownfilling stations.
110
Theextentofproductdifferentiation(whichaffectscrosspriceelasticityofdemand) Thestructureofbuyersintheindustry(includingthepossibilityofmonopsonypower) Theturnoverofcustomers(sometimesknownasmarketchurn)i.e.howmany customersarepreparedtoswitchtheirsupplieroveragiventimeperiodwhenmarket conditionschange.Therateofcustomerchurnisaffectedbythedegreeofconsumeror brandloyaltyandtheinfluenceofpersuasiveadvertisingandmarketing Characteristic Numberoffirms Typeofproduct Barrierstoentry Supernormalshortrun profit Supernormallongrun profit Pricing Nonpricecompetition Economicefficiency Innovativebehaviour Marketstructureandinnovation Whichmarketconditionsareoptimalforeffectiveandsustainedinnovationtooccur?Thisisa questionthathasvexedeconomistsandbusinessacademicsformanyyears. Highlevelsofresearchanddevelopmentspendingarefrequentlyobservedinoligopolistic markets,althoughthisdoesnotalwaystranslateitselfintoafastpaceofinnovation. TherecentworkofWilliamBaumol(2002)providessupportforoligopolyasmarketstructurebest suitedforinnovativebehaviour.Innovationisperceivedasbeingmandatoryforbusinessesthat needtoestablishacostadvantageorasignificantleadinproductqualityovertheirrivals. Assoonasqualitycompetitionandsaleseffortareadmittedintothesacredprecinctsoftheory, thepricevariableisoustedfromitsdominantposition..Butincapitalistrealityasdistinguished fromitstextbookpicture,itisnotthatkindofcompetitionwhichcountsbutthecompetitionwhich commandsadecisivecostorqualityadvantageandwhichstrikesnotatthemarginsofprofitsand theoutputsoftheexistingfirmsbutattheirfoundationsandtheirverylives.Thiskindof competitionisasmuchmoreeffectivethantheotherasabombardmentisincomparisonwith forcingadoor Supernormalprofitspersistinthelongruninanoligopolyandthesecanbeusedtofinance researchanddevelopment. PerfectCompetition Many Homogenous None Pricetaker High Weak Oligopoly Few Differentiated High Pricemaker Low VeryStrong Monopoly One Limited High Pricemaker Low Potentiallystrong
111
22.
CompetitionPolicyandRegulation
Competitionpolicycoversthedifferentwaysinwhichthecompetitionauthoritiesofnational governmentsandtheEuropeanUnionseektomakemarketsworkbetterandachieveahigher levelofeconomicefficiencyandeconomicwelfare. MainAimsofCompetitionPolicy Theaimofcompetitionpolicyispromotecompetitionmakemarketsworkbetterandcontribute towardsincreasedefficiencyandcompetitivenessoftheUKwithintheEuropeanUnionsingle market.Competitionpolicyaimstoensure o Widerconsumerchoice. o Technologicalinnovationwhichpromotesdynamicefficiency. o Effectivepricecompetitionbetweensuppliers. o Investigatingallegationsofanticompetitivebehaviourwhichaffectconsumerwelfare. TherearefourkeypillarsofcompetitionpolicyintheUKandintheEuropeanUnion 1. Antitrust&cartels:Thisinvolvestheeliminationofagreementswhichseektorestrict competitionincludingpricefixingandotherabusesbyfirmswhoholdadominantmarket position. 2. Marketliberalisation:Liberalisationinvolvesintroducingfreshcompetitioninpreviously monopolisticsectorssuchasenergysupply,telecommunicationsandairtransport. 3. Stateaidcontrol:CompetitionpolicyanalysesexamplesofstateaidmeasuresbyEU MemberStategovernmentstoensurethatsuchmeasuresdonotdistortcompetitioninthe SingleMarket(e.g.theprohibitionofafinancialgrantdesignedtokeepalossmakingfirm inbusinesseventhoughithasnoprospectoflongtermrecovery). 4. Mergercontrol:Thisinvolvestheinvestigationofmergersandtakeoversbetweenfirms (e.g.amergerbetweentwolargegroupswhichwouldresultintheirdominatingthemarket). TheRegulators Regulatorsareappointedbythegovernmenttooverseehowamarketworksandtheoutcomes thatresultforbothproducersandconsumers.Examplesofregulatorsinclude: Whatdotheregulatorsregulate? 1. Prices:Regulatorsaimtoensurethatcompaniesdonotexploitmonopolypowerby chargingexcessivepricesandpassonpartofanyreductionincoststoconsumersinlower prices 2. Standardsofcustomerservice:Companiesthatfailtomeetspecifiedservicestandards canbefinedorhavetheirfranchise/licencetakenaway.Theregulatormayalsorequire thatunprofitableservicesaremaintainedinthewiderpublicintereste.g.BTkeepingphone boothsopeninruralareasandinnercitiestheRoyalMailisstillrequiredbylawtoprovide auniformdeliveryserviceatleastonceadaytoallpostaladdressesintheUK 3. Openingupmarkets:Theaimhereistoencouragecompetitionbyremovingbarriersto entry.Thismightbeachievedbyforcingthedominantfirmintheindustrytoallowothersto useitsinfrastructurenetwork.Akeytaskfortheregulatoristofixafairaccesspricefor firmswantingtousetheexistinginfrastructure.
112
4. Regulationactsasaformofsurrogatecompetitionattemptingtoensurethatprices, profitsandservicequalityaresimilartowhatcouldbeachievedincompetitivemarkets. AntiTrustPolicyAbusesofaDominantMarketPosition Afirmholdsadominantpositionifitspowerenablesittooperatewithinthemarketwithouttaking accountofthereactionofitscompetitorsorofintermediateorfinalconsumers. Competitionauthoritiesconsiderafirmsmarketshare,whethertherearecrediblecompetitors, whetherthebusinesshasownershipandcontrolofitsowndistributionnetwork(achieved throughverticalintegration)andwhetherithasfavourableaccesstorawmaterials. Holdingadominantpositionisnotwronginitselfifitistheresultofthefirm'sowncompetitiveness againstotherbusinesses!Butifthefirmexploitsthispowertostiflecompetition,thisisdeemedto beananticompetitivepractice. ArecentexampleofthishasbeenthelonginvestigationandlegalbattlebytheEUCommission intotheallegedabuseofmarketpowerbyMicrosoft. AntiCompetitivePractices: Anticompetitivepracticesarestrategiesdesigneddeliberatelytolimitthedegreeofcompetition insideamarket.Suchactionscanbetakenbyonefirminisolationoranumberoffirmsengagedin explicitorimplicitcollusion.Since1998therehavebeennumerousinvestigationsinindustries suchaschemicals,banks,pharmaceuticals,airlines,beer,andpaper,plasterboard,food preservativesandcomputergames!Thesewerecoveredinthechapteronoligopoly. Examplesofanticompetitivepractices 1. Predatorypricing(alsoknownasdestroyerpricing)financedthroughcross subsidizationthishappenswhenoneormorefirmsdeliberatelysetspricesbelow averagecosttoincurlossesforasufficientlylongperiodoftimetoeliminate,discipline,or deterentrybyacompetitorandthentriestorecoupthelossesbyraisingpricesabovethe levelthatwouldordinarilyexistinacompetitivemarket. 2. Verticalrestraintinthemarket: a. Exclusivedealing:Thisoccurswhenaretailerundertakestosellonlyone manufacturersproduct.Thesemaybesupportedwithlongtermcontractsthatbind orlockinaretailertoasupplierandcanonlybeterminatedbytheretailerathigh financialcost.Distributionagreementsmayseektopreventinstancesofparallel tradebetweenEUcountries(e.g.fromlowerpricedtohigherpricedcountries). b. Territorialexclusivity:Thisexistswhenaparticularretailerisgiventhesolerights toselltheproductsofamanufacturerinaspecifiedarea. c. Quantitydiscounts:Whereretailersreceivelargerpricediscountsthemoreofa givenmanufacturer'sproducttheysellthisgivesthemanincentivetopushone manufacturer'sproductsattheexpenseofanother's. d. Arefusaltosupply:Wherearetailerisforcedtostockthecompleterangeofa manufacturer'sproductsorelsehereceivesnoneatall,orwheresupplymaybe delayedtothedisadvantageofaretailer. 3. Collusivepractices:Thesemightincludeagreementsonmarketsharing,pricefixingand agreementsonthetypesofgoodstobeproduced. PriceFixingTheOfficeofFairTrading UKcompetitionlawnowprohibitsalmostanyattempttofixpricesforexample,youcannot
113
o Agreepriceswithyourcompetitors,e.g.youcan'tagreetoworkfromashared minimumpricelist. o Agreetosharemarketsorlimitproductiontoraiseprices. o Imposeminimumpricesondifferentdistributorssuchasshops. o Agreewithyourcompetitorswhatpurchasepriceyouwillofferyoursuppliers. o Cutpricesbelowcostinordertoforceaweakercompetitoroutofthemarket. o Thelawdoesn'tjustcoverformalagreements.Italsoincludesotheractivitieswitha pricefixingeffect.Forexample,businessesshouldnotdiscussyourpricingplans withcompetitors. CartelsandthelawintheUK Cartelsareaparticularlydamagingformofanticompetitivebehaviourtakingactionagainstthem isoneoftheOFT'spriorities.UndertheCompetitionAct1998andArticle81oftheEUTreaty, cartelsareprohibited.Anybusinessfoundtobeamemberofacartelcouldbefinedupto10per centofitsworldwideturnover.Inaddition,theEnterpriseAct2002makesitacriminaloffencefor individualstodishonestlytakepartinthemostserioustypesofcartels.Anyoneconvictedofthe offencecouldreceiveamaximumoffiveyearsimprisonmentand/oranunlimitedfine. Source:OFTwebsite Therehavebeenmanyexamplesofallegationsofandinvestigationsinpricefixingandotherforms ofcollusivebehaviourinUKandEuropeanmarketsinrecentyears.Theyallprovideinteresting evidenceofhowthecompetitionauthoritiesbothintheUKandintheEuropeanUnionareusing theirenhancedpowersundernewcompetitionlawstoinvestigatepossibleinstancesofpricefixing oranticompetitivebehaviour. Somecollusivebehaviouristolerated/encouraged NotallinstancesofcollusivebehaviouraredeemedtobeillegalbytheEuropeanUnion CompetitionAuthorities.Practicesarenotprohibitediftherespectiveagreements"contributeto improvingtheproductionordistributionofgoodsortopromotingtechnicalprogressinamarket. o Developmentofimprovedindustrystandards/technicalstandardsofproductionand safetywhicheventuallybenefittheconsumer. o Researchjointventuresandknowhowagreementswhichseektopromoteinnovative andinventivebehaviourinamarket. MarketLiberalization ThemainprincipleofEUCompetitionPolicyisthatconsumerwelfareisbestservedbyintroducing competitioninmarketswheremonopolypowerexists.Frequently,thesemonopolieshavebeenin networkindustriesforexampletransport,energyandtelecommunications.Inthesesectors,a distinctionmustbemadebetweentheinfrastructureandtheservicesprovideddirectlyto consumersusingthisinfrastructure. Whileitisoftendifficulttoestablishasecond,competinginfrastructure,forreasonslinkedto investmentcostsandefficiency(i.e.thenaturalmonopolyargumentslinkedtoeconomiesof scaleandahighminimumefficientscale)itispossibleanddesirabletocreatecompetitive conditionsinrespectoftheservicesprovided. TheEuropeanCommissionhasdevelopedtheconceptofseparatinginfrastructurefrom commercialactivities.Theinfrastructureisthusthevehicleofcompetition.Whiletherightto exclusiveownershipmaypersistasregardstheinfrastructure(thetelephoneorelectricitynetwork forexampleorthesupplyofgasandelectricitytotheindividualhouseholdandbusiness),
114
monopolistsmustgrantaccesstocompanieswishingtocompetewiththemasregardsthe servicesofferedontheirnetworks. StateAidinMarkets Theargumentformonitoringstateaidgiventoprivateandstatebusinessesbymember Governmentisthatbygivingcertainfirmsorproductsfavouredtreatmenttothedetrimentof otherfirmsorproducts,stateaiddisruptsnormalcompetitiveforces.AccordingtotheEU CompetitionCommission,neitherthebeneficiariesofstateaidnortheircompetitorsprosperinthe longterm.Often,allgovernmentsubsidiesachieveistodelayinevitablerestructuringoperations withouthelpingtherecipientactuallytoreturntocostandnonpricecompetitiveness.Unsubsidised firmswhomustcompetewiththosereceivingpublicsupportmayultimatelyrunintodifficulties, causinglossofcompetitivenessandendangeringthejobsoftheiremployees. UnderthecurrentEuropeanstateaidrules,acompanycanberescuedonce.However,any restructuringaidofferedbyanationalgovernmentmustbeapprovedasbeingpartofafeasible andcoherentplantorestorethefirmslongtermviability.Governmentaiddesignedtoboost researchanddevelopment,regionaleconomicdevelopmentandthepromotionofsmall businessesisnormallypermitted. Herearesomerecentexamplesofthestateaid/statesubsidyissueinthenews.Theynearly alwaysrelatetoindustriesandbusinesseseithersufferingshorttermlosseswhosefutureisunder threatorthosestrugglingtocopeandadjusttolongtermeconomicdecline. ReportrulesoutstateaidfortheUKfishingindustry(BBCnews,July2008) EUsetsPolandshipyarddeadline(BBCnews,July2008) Alitaliacallsforurgentsupport(BBCnews,May2008) MergerPolicyintheUKandtheEuropeanUnion Corporaterestructuringisafactoflife.Thereisanaturaltendencyformarketstoconsolidateover takethroughaprocessofhorizontalandverticalintegration.Themainissueforcompetition policyiswhetheraproposedmergerortakeoverbetweentwobusinessesisthoughttoleadtoa substantiallesseningofcompetitivepressuresinthemarketandrisksleadingtoalevelof marketconcentrationwhencollusivebehaviourmightbecomeareality. Whencompaniescombineviaamerger,anacquisitionorthecreationofajointventure,this generallyhasapositiveimpactonmarkets:firmsusuallybecomemoreefficient,competition intensifiesandthefinalconsumerwillbenefitfromhigherqualitygoodsatfairerprices. However,mergerswhichcreateorstrengthenadominantmarketpositioncan,afterinvestigation, beprohibitedinordertopreventensuingabuses.Acquiringadominantpositionbybuyingout competitorsisincontraventionofEUcompetitionlaw. Companiesareusuallyabletoaddressthecompetitionproblems,normallybyofferingtodivest (selloroffload)partoftheirbusinesses.InDecember2007,theUKCompetitionCommission announcedthatthebroadcasterBSkyBwouldbeforcedtosellsomeofits17.9%stakeinITV. Suggestionsforfurtherreadingoncompetitionpolicy Callsformovesovermediamergers(BBCnews,June2008) USmergerformslargestairline(BBCnews,April2008)
115
BSkyBtoldtosellsharesinITV(BBCnews,January2008)
116
23.
PrivatisationandDeregulation
Privatisationbecameoneofthemostsignificantmicroeconomicpoliciesofthe1980sand1990s. Welookbrieflyatsomeoftheissuesinvolvedintransferringassetsfromthepublictotheprivate sectoroftheeconomy. Whatisprivatisation? Privatisationmeansthetransferofassetsfromthepublic(government)sectortotheprivate sector.IntheUKtheprocesshasledtoasizeablereductioninthesizeofthepublicsectorofthe economy.Stateownedenterprisesnowcontributelessthan2percentofGDPandlessthan1.5% oftotalemployment.Privatisationhasbecomeacommonfeatureofmicroeconomicreforms throughouttheworldnotleastinthetransitioneconomiesofEasternEuropeastheyhavemade progresstowardsbecomingfullyfledgedmarketeconomies. Nationalisation Nationalisationoccurswhenassetsaretakenbackintostateownershipthemostrecent examplesintheUKaretherenationalisationofNorthernRock(2007)andNetworkRail(formerly Railtrack)in2002. Majorprivatisations ThemajorprivatisationsintheUKoverthelasttwentyfiveyearshaveoccurredwiththefollowing businesses(theyearofprivatisationisinparenthesis). o AssociatedBritishPorts(1983) o BritishAerospace(1980)eventually mergedwithMarconiElectronic Systems o BritishAirportsAuthority(1986) subsequentlyboughtbyGrupo Ferrovialin2006 o BritishAirways(1987) o BritishCoal(1994)in1994,UK CoalsassetsweremergedwithRJB MiningtoformUKCoalplc o BritishGas(1986)In1997British GasplcdemergedCentricaplcand renameditselfBGplc(laterBGGroup plc).inBritainitisusedbyCentrica, whileintherestoftheworlditisused byBGGroup o BritishPetroleumInAugust1998, BritishPetroleummergedwiththe AmocoCorporation(Amoco),forming "BPAmoco." TheearlyexamplesofprivatisationsuchasthesaleofBritishTelecomtotheprivatesectorin 1984representedasimpletransferofownershipasshareswereofferedforsaleviathestock market.Morerecentlytheprivatisationprocesshasbecomemorecomplex.Thefocushas switchedtobreakingupexistingstatutorymonopolypowerthroughaprocessofderegulation andliberalisationofmarketsbasicallydesignedtointroducecompetitionwhereoncemonopoly powerwaswellestablished. o BritishRail(privatisedinstages between1994and1997)created Railtrackwhichwasrenationalised in2002 o BritishSteel(1988)BritishSteel mergedwiththeDutchsteelproducer KoninklijkeHoogovenstoformCorus Groupon6October1999.Coruswas boughtbyIndiansteelfirmTatain 2007. o BritishTelecom(1984) o NationalPowerandPowerGen(1990) 1990theCentralElectricity GeneratingBoardwassplitintothree generatingcompanies(Powergen, NationalPowerandNuclearElectric plc.)andelectricitytransmission company,NationalGridCompany. o Regionalwatercompanies
117
Marketforceshavebeenintroducedinsocialservices,theNHSandinhighereducation. Whatremainsofthepublicsector?
NorthernRockOrdinarySharePrice
Dailyclosingprice,spershare
13 12 11 10 9 8 13 12 11 10 9 8 7 6 5 4 3 2 1 0 97 98 99 00 01 02 03 04 05 06 07 08
GBP
7 6 5 4 3 2 1 0
Privatisationhasradicallychangedthepublicorgovernmentsectoroftheeconomyalthoughsince thecurrentLabourgovernmentcametopower,therehasbeenahugeriseintotalpublicsector employment,inparttheresultofalargeriseingovernmentspendingonthenationalhealth services.Thefollowingbusinessesremainpartofthepublicsector: o BritishNuclearFuelsplcaninternationalcompany,ownedbytheBritish government,concernedwithnuclearpower. o NetworkRailNetworkRailisa"notfordividend"companythatownsthefixed assetsoftheUKrailwaysystemthatformerlybelongedtoBritishRail,thenow defunctBritishstateownedrailwayoperator.NetworkRailownstheinfrastructure itself,railwaytracks,signals,tunnels,bridges,levelcrossingsandmoststations,but nottherollingstock.NetworkRailtookoverownershipbybuyingRailtrackplc, whichwasin"RailwayAdministration",for500millionfromRailtrackGroupplc. o TheRoyalMailRoyalMailhasbeenastateownedcompanysince1969and remainsapubliclimitedcompanywhollyownedbytheUKgovernment.TheRoyal MaulisregulatedbyPostCommwhichhasthepowertograntlicencestonew competitorsenteringthederegulatedmarketforhouseholdandbusinessmail services.ThemarketwasopeneduptofullcompetitioninJanuary2006.TheRoyal Mailretainsauniversalservicecommitment. o NorthernRockIntheautumnof2007thegovernmentannouncedthe nationalisationofNorthernRockallsharesinthebusinesswerehandedoverto theTreasury.Thegovernmentclaimedatthetimethatthiswouldbeatemporary periodofstateownershipandthatthebusinesswouldeventuallybereturnedtothe
118
privatesector.ThemainjustificationforthedecisionwasthatNorthernRock's businessmodelhadfailedbutthattheeconomicandsocialconsequencesof allowingthebusinesstogobustweretooseverehencetheneedforgovernment intervention.WeeksearlierNorthernRockranintoafinancialcrisiswhichledtothe firstrunonamajorUKbanksincethenineteenthcentury.Itwasforcedtoaskthe BankofEnglandforemergencyfunding.Withnationalisation,thedebtsofthebank weretakenontothepublicsectorfinances.Theseloansandguaranteeswere estimatedtobeworthmorethan50bn.Inthemonthssincethenationalisation, NorthernRockhasbeendownsizingitsactivities,reducingthesizeofitsmortgage loansbookandmakingseveralthousandemployeesredundant. Themaineconomicargumentsforprivatisationandderegulation Supportersofprivatisationbelievethattheprivatesectorandthedisciplineoffreemarketforces areabetterincentiveforbusinessestoberunefficientlyandtherebyachieveimprovementsin economicwelfare.Theargumentisthatextracompetitioninmarketswillleadtoreductionsin pricelevelsforconsumersandimprovementsovertimeindynamicefficiency. Privatisationwasalsoseenasawayofreducingtradeunionpowerandencouraginganincrease incapitalinvestmentasbusinesseswerenowfreetoraiseextrafinancialcapitalthroughthestock market. Themainargumentsagainstprivatisation Opponentsofprivatisationarguedthatstateownedenterpriseshadalreadyfacedcompetition whenpartofthepublicsectorandthatinseveralinstancesthetransferofownershipmerely replacedapublicsectormonopolywithaprivatesectormonopoly. Therewerecriticismsthatstateassetsweresoldoffbythegovernmentattoolowapriceandthat theconsequencesofprivatisationhasbeenadecreaseininvestmentandlargescalereductionsin employmentasprivatisedbusinesseshavesoughttocuttheiroperatingcosts. Deregulationofmarkets Anotherimportantpolicyinindustrieswherewelfareandefficiencymightbeaffectedbythe dominantmarketpowerofsomesuppliersistoopenupmarketsandencouragetheentryofnew suppliersaprocesscalledderegulationofproductmarkets.ExamplesofthisintheUK includetheopeningupofmarketsforhouseholdenergysupplies,theliberalisationofhousehold mailservicesandfinancialderegulationaffectingbothbanksandbuildingsocieties. TheexpansionoftheEuropeanSingleMarkethasacceleratedtheprocessofmarketliberalisation. TheSingleMarketseekstopromotefourfreedomsnamelythefreemovementofgoods, services,financialcapitalandlabour.Inthelongtermwecanexpecttoseethemicroeconomic effectsoftheEUSingleMarketworkingtheirwaythroughmanyBritishmarketsandthegeneral expectationisthatcompetitivepressuresforallbusinessesworkinginsidetheEuropeanUnionwill continuetointensify. Productmarketliberalisationinvolvesbreakingdownbarrierstoentryinindustriesandmaking themmorecontestable.Theaimistoboostmarketsupply,bringdownpricesforconsumers,and encourageanincreaseincompetition,investmentandproductivityleadingtoariseineconomic efficiency.Inthelongterm,ifproductmarketsbecomemorecompetitiveandinvestmentflowsinto theseindustries,therearemacroeconomicimplicationsforexampleanincreaseinaneconomys underlyingtrendrateofeconomicgrowthwhichmightcontributetoanimprovementinaverage standardsofliving. Utilityregulators Utilityregulatorsoverseetheactivitiesofcompaniesprivatisedoverthelasttwodecades.These formerstateownedutilitiesareregulatedtoensurethattheydonotexploittheirmonopolyposition. Themainaimsoftheregulatorshavebeentocreateandsimulatingthedisciplinesthatcompanies wouldexperienceinsideacompetitivemarket.Inthelongrun,thethrustofregulationhasbeento
119
encouragecompetitionbyeasingtheentryofnewsuppliersandmakingmarketsmore contestable. o Ofwat(waterservicesregulationauthority)Ofwatisthebodyresponsiblefor economicregulationoftheprivatisedwaterandsewerageindustryinEnglandand Wales.KeyissuesforOfwatatthemomentincludethethreatsofwatershortages, theproblemsofleaksandrisingwaterbills. o OfcomTheOfficeofCommunicationsistheUK'scommunicationsregulator o OfgemTheOfficeofGasandElectricityMarketsisthegovernmentregulatorfor theelectricityanddownstreamnaturalgasmarketsinGreatBritain.Itsprimaryduty istopromotechoiceandvalueforallgasandelectricitycustomers". o OfficeoftheRailRegulatorORRistheUKgovernment'sagencyforregulation ofthecountry'srailwaynetwork. PriceCappingfortheUtilities Pricecappinghasbeenadominantfeatureofregulationinrecentyearsalthoughthisisnow beingphasedoutasmostutilitymarketsbecomemorecompetitive.Innreality,settingapricecap, theindustryregulatorusuallyhasinmindasatisfactoryrateofreturnoncapitalemployedfor eachbusiness. Basicsofpricecapping Pricecapregulationisaformofinterventioninthepricemechanismwhichhasbeenappliedat variouspointsintimetoalloftheprivatisedutilitybusinessesintheUK.Pricecappingisan alternativetorateofreturnregulation,inwhichutilitybusinessesareallowedtoachieveagiven rateofreturn(orrateofprofit)oncapital.IntheUK,pricecappinghasbeenknownas"RPIX". Thistakestherateofinflation,measuredbytheConsumerPriceIndexandsubtractsexpected efficiencysavingsX.Inthewaterindustry,theformulais"RPIX+K",whereKisbasedoncapital investmentrequirementsdesignedtoimprovewaterqualityandmeetEUwaterqualitystandards. ThishasmeantincreasesintherealcostofwaterbillsformillionsofhouseholdsintheUK. Pricecappinghasmeantinmostcasesthataveragepricesforconsumershavefalleninrealterms althoughthishasnotbeenthecaseforallprivatisedindustries.Theassumptionisthatproductivity growthwillhelptoaccommodatethepricecaps.Profitsforutilitiescanriseprovidingthatefficiency levelsimprove(i.e.firmsareabletobringdowntheirunitlabourcosts) Argumentsforandagainstpricecappingfortheutilities Advantages o Cappingisanappropriatewaytocurtailthemonopolypowerofnaturalmonopolies. o Cutsintherealpricelevelsaregoodforhouseholdandindustrialconsumers(leadingto anincreaseinconsumersurplusandhigherreallivingstandardsinthelongrun). o Pricecappinghelpstostimulateimprovementsinproductiveefficiencybecauselower costsareneededtoincreaseaproducerstotalprofits. o Thepricecappingsystemisausefultoolforcontrollingconsumerpriceinflationinthe UK. Disadvantages o Pricecapshaveledtolargenumbersofjoblossesintheutilityindustries. o Settingdifferentpricecappingregimesforeachindustrydistortstheworkingoftheprice mechanism.
120
Yellandpricecapping PricecappingisstillusedinthemarketfortelephonedirectorieswhereYellhasadominant positioninthemarket.InJune2006itwasannouncedthatYellwouldstillbesubjecttoaprice cappingformulabecauseoftherelativeabsenceofcompetitionintheindustry.Accordingtothe CompetitionCommissionreport,"Yellcontinuestoholdapowerfulpositioninthismarketand competitionisnotworkingeffectively.Pricesarecappedatthemomentandwithoutthispricecap, advertiserswouldpaymorethaninawellfunctioningmarket.Atpresent,Yellissubjecttoayearly pricecapofRPIless6%soatthemoment,therealcostofadvertisingratesarefallingyearon year. PostCommapprovesariseinthepriceofstamps StamppricesroseinApril2006underacompromisedealbetweenregulatorPostCommandthe RoyalMail.Firstclassstampswouldrose2pto32pandsecondclassstampsby1pto22p,with thepossibilityofthemrisingto37pand25prespectivelyby2010.TheRoyalMailhadwantedto pushstampsupto39pand27ptohelppayforcapitalinvestmentandtopluga4bnholeinits pensionfund. Adaptedfromnewsreports TheUKrailindustrywasprivatizedbetween1994and1997andsincethattime,theaverageprice ofarailfarehasrisenfasterthaninflationatrendshowninthediagrambelow.Farechangesare announcedbytheAssociationofTrainOperatingCompanies.Despitecontinuinghighlevelsof governmentsubsidy,thetrainoperatingbusinesseshaveincreasedthosefaresthatare unregulatedbymorethaninflation,partlybecausetheyhavetohighfeestoNetworkRailfor accesstothetrackandinfrastructureandbecausetheyhavebeenmakingacontributiontowards improvementstorailsafety.
IndexofRailFaresintheUK
Monthlyfareindex,Jan1987=100
300
300
275
275
250
250
225
225
200
RailFares
200
175
175
150
OverallConsumerPriceIndex
150
125
125
100 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08
100
121
ChangingRoleoftheUtilityRegulators Graduallythemainutilityregulatorshavewithdrawnfrompriceregulationbecauseofthe increaseddegreeofcompetitioninthemarket.Themainfocusoftheregulatoryauthoritiesisnow toprovideimprovedpriceinformationforconsumerstomakepricesofdifferentsuppliersmore transparenttoimprovetheflowofinformationinthemarket. Theauthoritiesalsowanttoencouragefreetransferforconsumersbetweensuppliers(by monitoringandenforcingthenatureofsupplycontracts)andkeepingacloseeyeonanti competitivebehaviour. Intelecommunications,onekeydecisionmadeeventuallybyOfcomwastoenforceunbundlingof thelocalloop.Localloopunbundlingistheprocessofallowingtelecommunicationsoperatorsto usethetelephoneconnectionsfromthetelephoneexchange'scentralofficeorexchangetothe customerpremisesbeitahouseholdorabusinesslocation.IntheUKthishasmeantopeningup thetelephoneexchangesownedbyBritishTelecomandallowingbroadbandbusinessessuchas AOLUKandTiscalitoputintheirownequipmentandthensupplybroadbandservicesindirect competitionwithBTtohouseholds.Thevastmajorityofhouseholdsarewithinonemileoftheir localtelephoneexchange. Althoughlocallookunbundlinghastakentimetobecomewidespread,ithasbeenonefactor behindtherapidexpansionofmarketsupplyinbroadbandwhichisrevolutionisingtheUK telecommunicationsmarket. Oneoftheconsequencesofthegreaterlevelofcompetitioninthetelecommunicationsindustryin theUKisthatinJuly2006,OfcomwithdrewallpricecappingcontrolsonBritishTelecom.After22 yearsofhavingitspricescontrolleddirectlybyanindustryregulator,thismarkedanimportant milestoneintheprivatisationandmarketliberalisationprocess. Thedebateoverwaterprices
122
Waterandothercharges
Indexofprices,January1987=100
450 450
400
400
350
350
1987=100
300
WaterCharges
300
250
250
200
AllItemsRetailPriceIndex
200
150
150
100 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08
100
RPI:housing:water&othercharges(Jan1987=100) RPI:Allitemsretailpricesindex(January1987=100) Source:ReutersEcoWin
Whenwaterwasprivatisedin1989,theaveragehouseholdbillwasabout219.In2006,itwas 303up38%.Sincethelastpricereviewin2004,theaveragebillhasgoneup10%andis expectedtoriseabout20%plusinflationbetween2005and2010. Thesubsequentprofitsdeclaredbythewaterindustryhavepromptedanoutcrythatshareholders arebenefitingattheexpenseofcustomers.TheproblemhasbeenexacerbatedbyPRdisasters suchasThamesWater'shandlingofthedroughtlastsummerandanimpositionofahosepipeban whilethecompany'spipesleakedmillionsoflitresadayintotheground. Watercompaniesarguethattheincreasesareneededforlargescaleinvestmentsuchasmending burstpipestomeetleakagetargetsandimprovingwastedisposal.Thewaterindustryinvestsmore capitalinmaintenancethanallotherutilitiescombined.Sinceprivatisation,thesectorhasinvested over50bnhalfofthatisdowntomeetingEuropeanUniondirectives.In2004,itagreedwiththe regulatortospendafurther16.8bnto2010.Giventhatlastyearalone3.6bnlitresofwaterleaked fromUKpipeseveryday,itwouldappearthatthemoneyisneeded. Source:Adaptedfromnewspaperreports,March2007 Summarycommentsonprivatisation PrivatisationhaschangedthefaceoftheBritisheconomyoverthelasttwentyfiveyears.Over twentybusinesseshavebeentransferredfromthepublicsectortotheprivatesectorandmany remainingstatesectorenterprisesarenowsubjecttothedisciplinesofthemarket.Thetransferof ownershipfromonepartoftheeconomytoanotherhasbeen,inmanycases,ratherasuperficial change.Themorefundamentalchangeshaveoccurredwhenmonopolypowershavebeenbroken downeitherbecauseofregulatorslegislatingtoopenupthemarket,orbecauseoftheeffectsof widerinternationalchangessuchastheprocessofglobalisation. Theperformanceoftheprivatisedcompanieshasbeenpatchy.Mostofthemhaveseentheir monopolypowerserodedastheirmarketshavebecomemorecontestable.Someprivatisations
123
havenotworked,themostobviousexamplebeingthefailureofrailprivatizationandtheeventual collapseofRailtrackwhenitwentintoadministration. Thereremaincontroversialissuesaboutthesizeoftheprofitsthatsomeoftheprivatisedutilities aremaking,thewaterindustryisagoodexampleofthis.Inmostutilitymarketsthereisnow genuinelymorechoiceforconsumers.Andrealpricelevelshavecomedownoverthelongerterm. Suggestionsforfurtherreadingonprivatisationandnationalisation Argentinarenationalisesairline(BBCnews,July2008) CallforselloffoftheRoyalMail(BBCnews,May2008) GuardianspecialreportsontheNorthernRock NHSdentiststurningprivate(BBCnews,July2008) NHSrunslikeasupermarketwar(BBCnews,July2008)
124
24.
TheLabourMarket
Thelabourmarketisafactormarketitprovidesameansbywhichemployersfindthelabourthey need,whilstmillionsofindividualsoffertheirlabourservicesindifferentjobs. BackgroundtoLabourDemand MarginalRevenueProduct(MRPL)measuresthechangeintotalrevenueforafirmfromselling theoutputproducedbyadditionalworkersemployed. MRPL=MarginalPhysicalProductxPriceofOutputperunit o Marginalphysicalproductisthechangeinoutputresultingfromaddinganextraworker. o Thepriceofoutputisdeterminedintheproductmarketinotherwords,thepricethata businesscangetinthemarketfortheoutputthattheyhaveproduced. Asimplenumericalexampleofmarginalrevenueproductisshowninthenexttable: Labour employed 0 1 2 3 4 5 6 7 8 9 10 Capital(K) 5 5 5 5 5 5 5 5 5 5 5 Output(Q) units 0 30 70 120 180 270 330 370 400 420 430 MPP units / 30 40 50 60 90 60 40 30 20 10 Priceper unit() 5 5 5 5 5 5 5 5 5 5 5 MRP=MPPxP() / 150 200 250 300 450 300 200 150 100 50
Weareassuminginthisexamplethatthefirmisoperatinginaperfectlycompetitivemarketsuch thatthedemandcurveforfinishedoutputisperfectlyelasticat5perunit.Marginalrevenue productfollowsdirectlythebehaviourofmarginalphysicalproduct.Initiallyasmoreworkersare addedtoafixedamountofcapital,themarginalproductisassumedtorise.Howeverbeyondthe 5thworkeremployed,extraunitsoflabourleadtodiminishingreturns.Asmarginalphysical productfalls,sotoodoesmarginalrevenueproduct.Forexamplethe5 thworkertakenonadds $450tototalrevenuewhereasthe9thworkeremployedgeneratesjust100ofextraincome. Thestoryisdifferentifthefirmisoperatinginanimperfectlycompetitivemarketwherethedemand curveisdownwardsloping.Inthenextnumericalexampleweseethatasoutputincreases,the firmmayhavetoacceptalowerpriceperunitfortheproductitisselling.Thishasanimpactonthe marginalrevenueproductofemployingextraunitsoflabour.Oneagainthough,acombinationof diminishingreturnstoextralabourandafallingpriceperunitcausesmarginalrevenueproduct (eventually)todecline.Inourexamplebelow,itstartstofalloncethe7 thworkerisemployed.
125
Labour 0 1 2 3 4 5 6 7 8 9 10 Capital(K) 5 5 5 5 5 5 5 5 5 5 5 Output(Q) 0 25 60 100 150 210 280 360 430 450 460 MPP 25 35 40 50 60 70 80 70 20 10 Price() 10.0 9.60 9.00 8.70 8.20 7.90 7.70 7.00 6.80 6.50 6.00 MRP=MPPxP() 240 315 348 410 474 539 560 476 130 60
MRPtheorysuggeststhatwagedifferentialsresultinpartfromvariationsintheleveloflabour productivityandalsothevalueoftheoutputthatthelabourinputproduces. Themainassumptionsofthemarginalrevenueproductivitytheoryofthedemandforlabourare: o Workersarehomogeneousintermsoftheirabilityandproductivity(clearlyunrealistic!) o Firmshavenobuyingpowerwhendemandingworkers(theyhavenomonopsonypower.) o Tradeunionshavenoimpactonthelaboursupply(thepossibleimpactonunionsonwage determinationisconsideredlater.) o Thephysicalproductivityofeachworkercanbeaccuratelyandobjectivelymeasured andthemarketvalueoftheoutputproducedbythelabourforcecanalsobecalculated. o Theindustrysupplyoflabourisassumedtobeperfectlyelastic.Workersare occupationallyandgeographicallymobileandcanbehiredataconstantwagerate.This meansthatthemarginalcostoftakingonextraworkersisassumedtobeconstant. Theprofitmaximisinglevelofemployment Nowweconsiderhowmanypeopleabusinessmightdecidetoemploy.Theprofitmaximisinglevel ofemploymentoccurswhenafirmhiresworkersuptothepointwherethemarginalcostof employinganextraworkerequalsthemarginalrevenueproductoflabour.I.e.MCL=MRPL. Thisisshowninthelabourdemanddiagramshownbelow.
126
Wage Rate W2
Ariseinthewageratecausesacontraction oflabourdemandasthemarginalcostof employingextraworkersrises
W1
MarginalCostof EmployingLabour
W3
Theprofitmaximising levelofemploymentis wherethemarginal revenueproductoflabour =themarginalcostof employinglabour
MarginalRevenueProduct(MRPL)
E2
E1
E3
EmploymentofLabour(E)
LimitationsofMRPLtheoryoflabourdemand Althoughmarginalrevenueproducttheoryisausefulaspectoflabourmarketanalysisitis importanttobeawareofsomeofitslimitations: 1. Measuringproductivity:Oftenitis hardtomeasureproductivitybecause nophysicaloutputisproducedorthe outputmaynotbesoldatamarket price.Thismakesittoughtoplacea truevaluationontheoutputofeach extraworker.Howdoesonegoabout valuingthefinaloutputofpeople employedinteachingorthehealth service?Itiseasiertomeasurephysical outputinindustrieswhereatangible productisproducedeachday. 2. PayAwardBodies:Insomejobs wagesandsalariesareset independentlyofthestateoflabourdemandandsupply.Overfivemillionpublicsector workersforexamplefirefighters,councilworkers,nursesandteachershavetheirpayset accordingtodecisionsofindependentpayreviewbodieswithmarketforceshavingonly anindirectroleinsettingpayrates. 3. SelfemploymentandDirectorsPay:Thereareoverthreemillionpeopleclassifiedas selfemployedinBritain.Howmanyofthesepeoplesettheirwagesaccordingtothe marginalrevenueproductofwhattheyproduce?Andwhatofthosepeoplewhohavethe abilitytosettheirownpayratesasdirectorsorownersofcompanies? ShiftsintheDemandforLabour Thenumberofpeopleemployedateachwagelevelcanchangeandinthediagrambelowwesee anoutwardshiftofthelabourdemandcurve.Thecurveshiftswhenthereisachangeinthe conditionsofdemandinthejobsmarket.Forexample: Ariseinthelevelofconsumerdemandforaproductwhichmeansthatabusinessneeds totakeonmoreworkers(seebelowontheconceptofderiveddemand)
127
Anincreaseintheproductivityoflabourwhichmakesusinglabourmorecostefficient thanusingcapitalequipment Agovernmentemploymentsubsidywhichallowsabusinesstoemploymoreworkers Thelabourdemandcurvewouldshiftinwardsduringaneconomicslowdown/recessionwhen salesofgoodsandservicesareindecline,businessprofitsarefallingandmanyemployerscannot affordtokeepontheirpayrollsasmanyworkers.Theresultisoftenlabourredundanciesandan overalldeclineinthedemandforlabourateachwagerate.

Wage Rate
W1
LabourDemand(2) LabourDemand(1)
E1
E2
LabourasaDerivedDemand Thedemandforallfactorinputs,includinglabour,isaderived demandi.e.thedemanddependsonthedemandforthe productstheyproduce.Whentheeconomyisexpanding,we expecttoseeariseintheaggregatedemandforlabour providingthattheriseinoutputisgreaterthantheincreasein labourproductivity.Incontrast,duringarecessionora slowdown,theaggregatedemandforlabourwilldeclineas businesseslooktocuttheiroperationscostsandscalebackon production. Inarecession,businessfailures,plantshutdownsandshort termredundanciesleadtoareductioninthederiveddemand forlabour.Theconstructionindustryisanotherexampleofthederiveddemandforlabour.The decadelongpropertyboomintheUKhasledtorisingprices,outputandemployment.Butthe turnaroundinthehousingmarketislikelytoleadtothousandsofjoblossesduring2008and2009 asthemarketdemandforworkersinhousingconstructionhasshiftedinwards.
128
Carmakercutsjobsassalesfall ThebiggestcarmakerintheUnitedStates,GeneralMotors,issheddingjobsfromtheassembly planttotheboardroomasitstrugglestorespondtofallingdemandforitsvehicles.Soaringpetrol pricesandfearsofrecessionhaveputmotoristsoffbuyingitspickuptrucksandgasguzzling 4x4s.ManyAmericansareswitchingtosmaller,morefuelefficientcars,whichtendtobea specialityofAsianmotormanufacturers.GeneralMotorshasannouncedatwoyearpayfreeze andaprogrammeofvoluntaryredundanciesasitlookstoreducelabourcosts.GManditsrivals FordandChryslerhavealreadycutmorethan100,000jobssince2006. Source:Adaptedfromnewsreports,June2008 ElasticityofDemandforLabour
Wage Rate
Labourdemand(2)ismoreelasticperhapsbecausetheemployer caneasilyswitchtocapitalinputsasameansofproducinganoutputif wageratesweretoincrease Labourdemand(1)isrelativelyinelastice.g.0.4i.e.a10%fallinthe wageratemightonlyleadtoa4%expansionoflabourdemand
W1
W2 LabourDemand(2)
LabourDemand(1)
E1
E2
E3
Elasticityoflabourdemandmeasurestheresponsivenessofdemandforlabourwhenthereisa changeinthewagerate.Theelasticityofdemandforlabourdependsonthesefactors: 1. Labourcostsasa%oftotalcosts:Whenlabourexpensesareahighproportionoftotal costs,thenlabourdemandtendstobeelastic.Inmanyservicejobssuchascustomer servicecentres,labourcostsareahighproportionofthetotalcostsofabusiness. 2. Theeaseandcostoffactorsubstitution:Labourdemandwillbemoreelasticwhena firmcansubstitutequicklyandeasilybetweenlabourandcapitalinputs.Whenspecialised labourorcapitalisneeded,thenthedemandforlabourwillbemoreinelastic.Forexample itmightbefairlyeasyandcheaptoreplacesecurityguardswithcamerasbutahotelwould finditalmostimpossibletoreplacehotelcleaningstaffwithmachinery! 3. Thepriceelasticityofdemandforthefinaloutputproducedbyabusiness:Ifafirmis operatinginahighlycompetitivemarketwherefinaldemandfortheproductispriceelastic, theymayhavelittlemarketpowertopassonhigherwagecoststoconsumers. LabourSupply
129
Thelaboursupplyreferstothetotalnumberofhoursthatlabouriswillingandabletosupplyat agivenwagerate.Itcanalsobedefinedasthenumberofworkerswillingandabletoworkina particularjoborindustryforagivenwage. Thelaboursupplycurveforanyindustryoroccupationwillbeupwardsloping.Thisisbecause,as wagesrise,otherworkersenterthisindustryattractedbytheincentiveofhigherrewards.They mayhavemovedfromotherindustriesortheymaynothavepreviouslyheldajob,suchas housewivesortheunemployed.Theextenttowhichariseintheprevailingwageorsalaryinan occupationleadstoanexpansioninthesupplyoflabourdependsontheelasticityoflaboursupply.

Wage Rate LabourSupply Wage Rate LS1 LS2
W2 W1 W3 W1
D2 D1
E3 E1 E2
Employment
E1
E2
Employment
Keyfactorsaffectinglaboursupply Thesupplyoflabourtoaparticularoccupationisinfluencedbyarangeoffactors: 1. Therealwagerateonofferintheindustryitselfhigherwagesraisetheprospectof increasedfactorrewardsandshouldboostthenumberofpeoplewillingandabletowork. 2. Overtime:Opportunitiestoboostearningscomethroughovertimepayments,productivity relatedpayschemes,andshareoptionschemes. 3. Substituteoccupations:Therealwagerateonofferincompetingjobsisanotherfactor becausethisaffectsthewageandearningsdifferentialthatexistsbetweentwoormore occupations.Soforexampleanincreaseintherelativeearningsavailabletotrained plumbersandelectriciansmaycausesomepeopletoswitchtheirjobs. 4. Barrierstoentry:Artificiallimitstoanindustryslaboursupply(e.g.throughthe introductionofminimumentryrequirementsorotherlegalbarrierstoentry)canrestrict laboursupplyandforceaveragepayandsalarylevelshigherthisisparticularlythecase inprofessionssuchaslegalservicesandmedicinewheretherearestrictentrycriteriato theprofessions. 5. Improvementsintheoccupationalmobilityoflabour:Forexampleifmorepeopleare trainedwiththenecessaryskillsrequiredtoworkinaparticularoccupation.
130
6. Nonmonetarycharacteristicsofspecificjobsincludefactorssuchasthelevelofrisk associatedwithdifferentjobs,therequirementtoworkantisocialhoursorthenon pecuniarybenefitsthatcertainjobsprovideincludingjobsecurity,opportunitiesfor promotionandthechancetoliveandworkoverseas,employerprovidedinworktraining, employerprovidedorsubsidisedhealthandleisurefacilitiesandotherinworkbenefits includingoccupationalpensionschemes. 7. NetmigrationoflabourtheUKisamemberoftheEuropeanUnionsinglemarketthat enshrinesfreemovementoflabourasoneofitsguidingprinciples.Arisingflowofpeople seekingworkintheUKismakinglabourmigrationanimportantfactorindeterminingthe supplyoflabouravailabletomanyindustriesbeittorelieveshortagesofskilledlabourin theNHSoreducation,ortomeettheseasonaldemandforworkersinagricultureandthe constructionindustry. Elasticityoflaboursupply
Inelasticandelasticlaboursupplycurves
Aperfectlyelasticlaboursupplycurve
Wage Rate LabourSupply (shortrun) b W2 a W1 W3 c
Wage Rate
Labour Supply Labour Supply (longrun) D2 D1 D2 D1
E1
E3
Employment
E1
E2
Employment
Theelasticityoflaboursupplytoanoccupationmeasurestheextenttowhichlaboursupply respondstoachangeinthewagerateinagiventimeperiod.Inlowskilledoccupationsweexpect laboursupplytobeelastic.Thismeansthatapoolofreadilyavailablelabourisemployableata fairlyconstantmarketwagerate.Wherejobsrequirespecificskillsandlengthyperiodsof training,thelaboursupplywillbemoreinelasticbecauseitishardtoexpandtheworkforceina shortperiodoftimewhendemandforworkershasincreased. Inmanyprofessionsthereareartificialbarrierstotheentryofworkers.ExamplesincludeLaw, AccountancyandMedicine.Theneedforhighleveleducationalqualificationsmakesthesupplyof newlyqualifiedentrantstotheseoccupationsquiteinelasticintheshortrunandisonereasonwhy theseworkersmayearnahigherrealwagethanaveragesalaries.
131
Equilibriumwages
Theequilibriumpriceoflabour(marketwagerate)inagivenmarketisdeterminedbytheinteraction ofthesupplyanddemandforlabour.Employeesarehireduptothepointwheretheextracostof hiringanemployee(theirwage)isequaltotheadditiontosalesrevenuefromhiringthem,theirMRP.
Real Wage Rate
Real Wage Rate Labour Supply Labour Supply W3 W1 W2
W1
D3 D1 D2 D1
E1
Employment
E2
E1
E3 Employment
WageDifferentials ThereisawidegulfinpayandearningsratesbetweendifferentoccupationsintheUKlabour market.Eveninlocallabourmarketstherewillbevariationsinpaylevelsforexample,inLondon busdriversworkingfordifferentbuscompaniescanseedifferencesintheirbasicpayofupto 6,000ayear? Noonefactorexplainsthegulfinpaythatexistsandpersistsbetweenoccupationsandwithineach sectoroftheeconomy.Someoftherelevantfactorsarelistedbelow 1. Compensatingwagedifferentialshigherpaycanoftenbesomerewardforrisktaking incertainjobs,workinginpoorconditionsandhavingtoworkunsocialhours. 2. Equalisingdifferenceandhumancapitalinacompetitivelabourmarketequilibrium, wagedifferentialscompensateworkersfor(opportunityanddirect)costsofhumancapital acquisition.Thereisanopportunitycostinacquiringqualificationsmeasuredbythe currentearningsforegonebystayinginfullorparttimeeducation. 3. Differentskilllevelsthegapbetweenpoorlyskilledandhighlyskilledworkersgetswider eachyear.Onereasonisthatthemarketdemandforskilledlabourgrowsmorequickly thanthedemandforsemiskilledworkers.Thispushesuppaylevels.Highlyskilledworkers areoftenininelasticsupplyandrisingdemandforcesupthe"goingwagerate"inan industry.
132
4. Differencesinlabourproductivityandrevenuecreationworkerswhoseefficiencyis highestandabilitytogeneraterevenueforafirmshouldberewardedwithhigherpay.City economistsandanalystsareoftenhighlypaidnotleastbecausetheycanclaimannual bonusesbasedonperformance.Topsportsstarscancommandtopwagesbecauseof theirpotentialtogenerateextrarevenuefromticketsalesandmerchandising. 5. Tradeunionsandtheircollectivebargainingpowerunionsmightexercisetheir bargainingpowertooffsetthepowerofanemployerinaparticularoccupationandindoing soachieveamarkuponwagescomparedtothoseonoffertononunionmembers 6. Employerdiscriminationisafactorthatcannotbeignoreddespiteovertwentyyearsof equalpaylegislationinplace
Real Wage Rate Real Wage Rate W2 Ls
Ls W1
Ld
Ld
E1 Employment
E2
Employment
Stickywagesinthelabourmarket Economistsoftenrefertotheexistenceofstickywages.Inafullyflexiblelabourmarket,a decreaseinthedemandforlabourshouldcauseafallinwagesandacontractioninemployment justlikeanydemandcurveshiftingdown. However,stickywagesreferstoasituationinwhichtherealwageleveldoesn'tfallimmediately, partlybecausemostemployeeshavewagesspecifiedinemploymentcontractsthatcannotbe renegotiatedimmediately,andbecauseworkers(perhapsprotectedbytheirtradeunions)are resistanttocutsinnominalwages.Ifthewagelevelcannotfallwhendemandfalls,itleadstoa muchbiggerdropinemploymentand,moreimportantly,involuntaryunemploymentbecauseof afailureofthelabourmarkettoclear. Theevidenceforstickywagesisagoodcounterargumenttoneoclassicalmodelsofthelabour marketthatsuggestthatrealwagelevelsrespondflexiblytoanychangesinlabourdemandand supplyconditions
133
Governmentpoliciesandthelaboursupply Themainpoliciesdesignedtoincreasethesupplyoflabouravailabletotheeconomyareas follows: 1. Reformstothesystemofdirecttaxation:Inthe1980s,Thatcheriteeconomicsfocused oncuttingincometaxratesparticularlyatthetopendandswitchingawayfromdirect towardsindirecttaxation.Morerecently,successivegovernmentshavetendedtofocus moreonreductionsinthelowerratesofincometaxandtaxallowancesforlowerpaid workers.Thetheoreticalidearemainsbroadlythesame,thatlowerdirecttaxesincrease theposttaxrewardtoworkingandactasanincentiveformorepeopletojointhelabour supply.In2007thegovernmentannouncedthatthe10%startingrateofincometaxwould bewithdrawnin2008andthatthebasicrateoftaxwouldbecutfrom22%to20%. 2. Reformstothebenefitssystem:Theemphasisherehaschangedawayfromtherather crudeideaofcuttingtherealandrelativevalueofwelfarebenefitstowardsencourage peopleintosearchingforwork,towardsarelianceontaxcredits(forexampletheWorking FamiliesTaxCredit)togiveparentswithchildrenagreaterfinancialincentivestowork.The aimistoreducethedisincentiveproblemscreatedbytheunemploymentandpovertytrap. 3. Increasedinvestmentineducationandtraining:Thisisdesignedtoboostthehuman capitalofthelabourforceandimprovetheoccupationalmobilityofthelabourforceto meetthechangingdemandsofemployersacrossdifferentindustries. 4. Amorerelaxedapproachtolabourimmigration:Particularlywherethereareshortages ofworkerswithskillssuchasconsultantsandfullytrainednursesintheNHS,orshortages ofteachersincertainsubjects.Theeffectofnetinwardmigrationonthelaboursupplyis showninthediagrambelow.
LabourSupply Labour Supply with migration
Real Wage Rate
Stronginflowsoflabourintotheeconomycan havetheeffectofincreasingthelaboursupply Thisputsdownwardpressureonrealwages (foragivenleveloflabourdemand)e.g. throughhelpingtorelievelabourshortagesin particularindustriesandoccupations Ifmigrationprovidesaboosttothelabour supplyandtolabourproductivity,thereisthe prospectofanoutwardshiftinacountryslong runaggregatesupply
W1 W2
Labour Demand
E1
E2
Employment

134
Theworkleisuretradeoff Oncesomebodyhasenteredthelabourforcehowmanyhourswilltheychoosetowork? Formanypeople,thehourstheyworkarefixedbytheiremployersandtheyhavelittleorno flexibilityinthetotalnumberofhourstheysupply.Butthemajorityofworkershaveanopportunity atsomepointtoworkadditionalhours,orperhapsswitchfromafulltimejobtoaparttime position.Andtheofficialdataprobablyunderstatesthetruenumberofpeoplewhoare moonlightingandworkinginasecondorthirdjobbecauseoftheexpansionoftheshadow economywhichhadencouragedtheexpansionofashadowlabourforce. Oftenemployersadjustthenumberofhoursofworkavailabletomeettheiremployees preferences.Oversevenmillionpeoplearenowinparttimeemploymentandmuchofthisgrowth inparttimejobshasbeensustainedbecauseitmeetsthepreferencesofpeoplelookingfor greaterflexibilityintheirworkingarrangements. Economictheorywouldsuggestthattherealwageisakeydeterminantofthenumberofhours. Therealwageisthemoneywagerateadjustedforchangesinthepricelevelanditmeasuresthe quantityofgoodsandservicesthatcanbeboughtfromeachhourworked.Anincreaseinthereal wageonofferinajobshouldleadtosomeonesupplyingmorehoursoveragivenperiodoftime, althoughthereisthepossibilitythatfurtherincreasesinthewageratemighthavelittleeffectonan individualslaboursupply.Indeed,thereisthepossibilityofabackwardbendingindividuallabour supplycurve.Thisisillustratedinthenextdiagram.
Real Wage Rate IndividualLabour Supply(2) IndividualLabour Supply(1)
L1
L3 L2
HoursofWork Supplied(LS)
Twodistinctindividuallaboursupplycurvesareshown.Inthefirstcurve,higherrealwagesdolead toanincreaseinthenumberofextrahourssupplied,althoughtherateatwhichtheindividualis preparedtogiveuptheirleisuretimeandworklongerhoursdiminishesastherealwagerises.But thelaboursupplycurvemeetsthestandardpredictionthathigherwagesattractpeopletowork longerhours.Inthesecondcurve,formostoftherangeofrealwages,thesamepredictionholds true,butwhenasrealwagesstepupwards,eventuallyanindividualmaychoosetoactuallywork fewerhours(ceterisparibus)givinguswhatissometimestermedabackwardbendinglabour supplycurve.

135
Incomeandsubstitutioneffects Tounderstandwhythismighthappenweconsidertheincomeandsubstitutioneffectsthatarise fromachangeintherealwagebeingpaidtoanindividualworker.Westartwiththeincomeeffect. o Theincomeeffect:Higherrealwagesincreasetheincomethatsomeonecanearnfroma job,buttheyalsomeanthatthehoursofworkneededtoearnenoughtopayforaproduct declines.Higherpaylevelsmeanthatatargetrealwagecanbeachievedwithfewerhours oflaboursupply.Sothisincomeeffectmightpersuadepeopletoworklesshoursandenjoy extendedleisuretime. o Thesubstitutioneffect:Thesubstitutioneffectofahigherwagerateshould unambiguouslygivepeopleanincentivetoworkextrahoursbecausethefinancialrewards ofworkingareraised,andtheopportunitycostofnotworking(measuredbythewages givenupwhenpeopleoptforleisureinstead)hasincreased. Withtheincomeandsubstitutioneffectsworkinginoppositedirections,thereisnohardandfast predictionaboutwhetherpeoplewillchoosetoincreasetheirlaboursupplyasrealwagesincrease. Aretheincomeandsubstitutioneffectsdifferentformalecomparedtofemaleworkers?What aboutyoungerworkersenteringthelabourmarketforthefirsttimewhoarelookingtosaveto financeadepositonahouseortofundothermajoritemsofspending?Howmightpeoplecloserto retirementagerespondtochangesinrealwages?Whatofworkersinhouseholdswhereatleast someoneelseisinpaidemploymentcomparedtoahouseholdwherethereisonlyonemain breadwinner? TheavailableevidencefortheUKlabourmarketismixed,indeedsomeanalystsbelievethatin aggregate,theincomeandsubstitutioneffectseffectivelycanceleachotheroutsothatrealwages havenoimpactontheindividuallaboursupply! Theimportanceofincentives Incentivesareimportantinaffectingthelaboursupply.Mostofusrelyonincomefromourworkto payforthethingsweneedandhigherpayandbetterconditionsshouldbeanincentiveperhapsto worksomeextrahoursorsearchforworkinthefirstplace.Butformanyworkersthereare disincentivestosupplytheirlabourandtheseproblemsoftenaffectpeopleinlowlypaidjobs. Thisisknownastheproblemofthepovertytrapandthereisagoodexampleintheminicase studybelow. ThePovertyTrapworsensinScotland Thesoaringcostofchildcareisworseningthepovertytrapaccordingtoanewreport commissionedforthesavetheChildrenFundinScotland.MorethanonequarterofScotsparents onlowincomescannotworkfulltimebecauseofthecostofregisteredchildcarewhichhasrisen bymorethan10percentthisyearacrossmostofthecountry.JoanneBrady,asinglemotherof twochildrenfromGlasgow,isunabletoworkbecauseshelosesmoreinmeanstestedchildtax creditsthanshegainsinincome.Theytake20percentoffforeachchildwhenyougotowork. Youstillhavetopayyourhousing,travelandlunchesandit'sjustnotadequate.MsBrady,27,is amongthe28percentofparentswithchildrenunder18andanincomeoflessthan15,000. Source:Newsreports,July2008
136
Suggestionsforfurtherreadingonlabourdemandandlaboursupply Eachofthesearticleshasbeenselectedbecauseitisrelevanttotheideasdiscussedinthis chapteronthedemandforandsupplyoflabourindifferentlabourmarketsandhowthiscanaffect wagesandemployment. LabourDemand AirlineQantastocut1,500jobs(BBCnews,July2008) Newbiomasspowerstationwillcreate500jobs(BBCnews,July2008) Risingoilpricecreatingnewdivejobs(BBCnews,July2008) USbossesshedthousandsofjobs(BBCnews,July2008) LabourSupply Carersneedhelptogettowork(BBCnews,July2008) Farmersfearstrawberryshortage(BBCnews,May2008) Thefactorspullingmigrantworkershome(BBCnews,July2008) WagesandWageDifferentials Busdriversdemandequalpayrate(BBCnews,July2008) Femaleworkerswininpayruling(BBCnews,July2008) GovernmentandUnionsclashoverpublicsectorpay(BBCnews,April2008) HardRockwagesbelowtheminimum(BBCnews,July2008) Livingwagetomeetrisingcosts(BBCnews,July2008) Migrantworkerpaid8.80aweek(BBCnews,June2008) TUCcallsforminimumwagefortrainees(TUC,August2008) GovernmentPoliciestowardWorkIncentives BacktoBeveridge(TheTimes,July2008) Claimantstoworkforbenefits(BBCnews,July2008) MigrantworkersleavetheUK(BBCPoliticsShow,June2008) UKgrowthboostedbyimmigration(BBCnews,December2007)
137
25.
MonopsonyintheLabourMarket
Withincreasingfrequencythesedayswereadinthemediaofstoriesofpeopleofteninlowpaid jobswhoclaimthattheyarebeingunderpaidforthejobthattheydo.Therearemanypossible reasonsforthisandoneofthemistheeffectofanemployerusingtheirmonopsonypower.Thisis thefocusofthischapter. Monopsony Amonopsonyproducerhasbuyingpowerinthelabourmarketwhenseekingtoemployextra workersandmayusethatbuyingpowertodrivedownwagerates. Themonopsonistknowsthattheyfaceanupwardslopinglaboursupplycurve,inotherwords,to attractmoreworkersintheirindustry,theymustpayahigherwageratesotheaveragecostof employinglabourriseswiththenumberofpeopletakenon.Becausetheaveragecostoflabour isincreasing,themarginalcostofextraworkerswillbeevenhigher,sinceweassumethatan increaseinthewageratepaidtoattractoneextraworkermustalsobepaidtoexistingworkers.
Amonopsonyisamarketdominatedbyasinglebuyer.Amonopsonisthasthemarketpower tosetthepriceofwhateveritisbuying(fromrawmaterialstolabourinputs) Wage Rate (W)
MarginalCostof Labour(MCL)
MRPL
Labour Supply (ACL)
Wq
Demand=MRPL Eq EmploymentofLabour(E)
Theprofitmaximisinglevelofemploymentiswherethemarginalcostoflabourequateswiththe marginalrevenueproductofemployingextraworkers.Inthediagram,Eqworkersaretaken on,butthemonopsonistcanemploytheseworkersatanaveragewagerateofWqapaylevel belowthemarginalrevenueproductofthelastworker.Inthissense,themonopsonistisexploiting labourbynotpayingthemthefullvalueoftheirmarginalrevenueproduct. Tradeunionsmayseektocounterbalancethemonopsonypowerofanemployerbycontrolling aspectsofthelaboursupplyandbyusingwhatevercollectivebargainingpowertheypossessto negotiatewageshigherwithoutbeingattheexpenseofemploymentlevels.

138
Examplesofmonopsonyemployers Goodexamplesmightbethemajoremployerinasmalltown(e.g.acarplant,amajorsupermarket ortheheadofficeofabank)nursinghomesasemployersofcareassistants,bigrestaurantsor pubsinalocaltown.Thegovernmentcanalsohavemonopsonypowerasthemajoremployerin theteachingprofessionortheNHS(thethirdlargestemployerintheworldbehindtheIndian RailwaysandtheChineseRedArmy! Howmightaminimumwageimpactonemploymentandwagedecisionsofamonopsony? Becausetheminimumwageisapayfloor,themonopsonistcannotpayawagebelowit,sothe NMWeffectivelybecomesthemarginalandaveragecostcurveforhiringworkersupto employmentlevelEmin.Thereaftertohireadditionalstaff,thewageratemustbebidup,again creatingadivergencebetweentheaverageandmarginalcostoflabour.Theeffectonthediagram isthatwithanappropriatelysetrate,theprofitmaximisinglevelofemploymentafteraminimum wageishigher(E2)andthewageratepaidtolabourhasalsoincreased(W2).Sointhisexample, makingcertainassumptions,aminimumwagemightactuallyboosttotalemploymentandsecure betterpayforworkersinoccupationsandindustrieswherethereissomemonopsonisticpower amongthebuyersoflabour. Forsomeindustriesithasbeenanimportantcounterweighttoemployerswhoroutinelypaylow wages.AstudyfortheBritishRetailConsortiumpublishedinthesummerof2007foundthat96per centofworkersintheUKhospitalityindustryand75percentofretailandwholesaleworkers earnedonlythebasicminimumwage,whichrosefrom5.35to5.52anhourinOctober2007.
Wage Rate (W) Marginal Costwith NMW MRPL NMW National MinimumWage Wq Labour Supply (ACL)
Demand= MRPL Eq E2 EmploymentofLabour(E)
Suggestionsforfurtherreadingonmonopsonypowerinthelabourmarket Unionwarningonmigrantslavelabour(BBCnews,November2007) Givemeafairanddecentwage(BBCnews,April2008) Firmaccusedofshockingabuse(BBCnews,April2008) Gangmasterslicenceisrevoked(BBCnews,May2008) Thousandsaccusedbygangmasters(BBCnews,June208)

139
26.
DiscriminationintheLabourMarket
Employersmaynottreatworkers,betheyactualorpotentialemployeesinthesamewayin whichcasediscriminationissaidtooccur.Itisapossiblecauseofmarketfailureandweconsider differentaspectsoflabourmarketdiscriminationinthischapter. Whatisdiscrimination? NobelprizewinningeconomistKennethArrowhasdefineddiscriminationasthevaluationinthe marketplaceofpersonalcharacteristicsoftheworkerthatareunrelatedtoworkerproductivity. Thesepersonalcharacteristicsmaybesex,race,height,appearance,age,nationaloriginor sexualpreferenceorindeedanyotheridentifiablecharacteristic. Discriminationisacauseoflabourmarketfailureandasourceofinequityinthedistribution ofincomeandwealthanditisusuallysubjecttogovernmentinterventione.g.throughregulation andlegislation. Discriminatorytreatmentofminoritygroupsleadstolowerwagesandreducedemployment opportunities,includinglesstraining,morejobinsecurityandfewerpromotions.Theresultisthat groupsexposedtodiscriminationearnlessthantheywouldandsufferafallinrelativeliving standards. Whydoesdiscriminationoccurinthelabourmarket? 1. The'Taste'Model(GaryBecker)Discriminationarisesherebecauseemployersand workershaveadistasteforworkingwithpeoplefromdifferentethnicbackgroundsorfinal customersdislikebuyinggoodsfromsalespeoplefromdifferentracesi.e.peoplepreferto associatewithothersfromtheirowngroup.Theyarewillingtopayapricetoavoidcontact withothergroups.Withreferencetorace,thisisequivalenttoracialprejudice. 2. EmployerignoranceDiscriminationarisesbecauseemployersareunabletoobserve directlytheproductiveabilityofindividualsandthereforecharacteristicssuchasgenderor racemaybeusedasproxiestheemployerthroughignoranceorprejudiceassumesthat certaingroupsofworkersarelessproductivethanothersandislesswillingtoemploy them,orpaythemawageorsalarythatfairlyreflectstheirproductivity,experienceand applicabilityforaparticularjob. 3. OccupationalcrowdingeffectsFemalesandminoritiesmaybecrowdedintoacluster oflowerpayingoccupations. DiscriminationagainstfemaleworkersthegenderpaygapintheUK Thereislittledoubtthatapermanentgapexistsbetweenaveragepayratesforfemalesandmales intheUKlabourmarket.Howeverthereisevidencethatthisgapisclosingalbeitslowly.Areport bytheWomenandWorkCommissionreleasedinFebruary2006foundthatwomeninfulltime workwereearning17%lessthanmen.ThegenderpaygapisnotconfinedtotheUK.Average earningsforwomenintheEuropeanUnionare15%lessthanmen.InAmerica,thedifferencein medianweeklypayisaround20%.Evidenceofthegenderpaygapcomeseachyearfromthe NewEarningsSurvey. 1. Hourlyearnings:Since1999womenshourlyearningshaveremainedatjustover80per centofmensearnings.Theaveragehourlywagerateformenin2003was12.88while therateforwomenwas10.56. 2. WeeklyearningsAverageweeklyearningsoffulltimeemployeesin2003forwomen (396.0)were75.4percentofthoseformen(525.0).Women'sweeklyearningswere lowerthanmen'spartlybecausetheyworkedonaverage3.5fewerhoursperweek
140
Britain'sequalpayrecordispoorwhencomparedtootherEuropeancountriestenthoutoffifteen countriessurveyed.Overalifetime,thegenderpaygapcancostachildlessmidskilledwoman justunder250000 WhatfactorsexplainthegenderpaygapintheUK? 1. Humancapital:i.e.therearedifferencesineducationallevelsandworkexperience betweenmalesandfemales.Thisismostmarkedwhenonecomparesmarriedmaleswith marriedfemales.Breaksfrompaidwork,includingtimetoraiseafamily,alsoimpacton women'slevelofworkexperience.Itiscalculatedthatamidskilledmotheroftwo,losesan additional140000ofherpotentialearningsafterchildbirth. 2. Parttimeworking:asignificantproportionofwomenworkparttimeandparttimework typicallypayslesswellthanfulltimejobs.Nearly50%ofwomenintheUKwhoseyoungest childisunder5arenotinemploymentandofthosewhodowork,65%workparttime. 3. Travelpatterns:onaverage,womenspendlesstimecommutingthanmenwiththeresult thattheywillhaveasmallerpoolofjobstochoosefrom.Itmayalsoresultinlotsofwomen wantingworkinthesamelocationneartowheretheylivewhichwillresultinlower equilibriumwagesforthosejobs. 4. Occupationalsegregation:women'semploymenttendstobeconcentratedincertain occupations.Indeed,indeed60percentofworkingwomenworkinjust10occupations. Occupationswhicharefemaledominatedareoftenrelativelypoorlypaidjobs(e.g.Caring, Cashiering,Catering,CleaningandClericaljobs)andthereiscontinuedunder representationinhigherpaidjobswithinoccupationsthesocalled"glassceiling"effect. 5. Employerdiscrimination:WorkbytheLSEcalculatesthatupto42%ofthegenderpay gapisattributabletodirectdiscriminationagainstwomen.Since1995thenumberofequal paycasesregisteredwithemploymenttribunalshasmorethandoubled. 6. Theeffectsofmonopsonypower:Femalesmayberelativelygeographicallyimmobile (becausetheyaretiedtotheirhusbands'placeofemployment)andmaybepaidlessthan acompetitivewagebyamonopsonistemployer. Areductioninthedemandforfemalelabourrelativetomalelabourwillresultinareductioninthe employmentoffemalesandareductionintherelativewagesoffemalescomparedtomales (assumingthatsupplyoffemalelabourisnotperfectlyelastic.) GovernmentInterventiontoreducethegendergap Interventionhastakenseveralforms.TheEqualPayActintroducedin1970soughttoprovide legalprotectionforfemaleworkersandencouragedemployerstobringthepayformalesand femalesintoline.TheSexDiscriminationActof1975outlawedunequalopportunitiesfor employmentandpromotionintheworkplacebecauseofgenderanditsetuptheEqual OpportunitiesCommission. Attentionhasswitchedinrecentyearsawayfromlegislationtowardsencouragingmorewomento stayoninfurtherandhighereducationprovidingandtargetedassistanceforsingleparentstofind workandtherebyincreasethelabourmarketparticipationratioamongfemaleworkers. EarningsDifferentialsbetweenEthicGroups EthnicminoritygroupsintheUKaremorelikelytoexperienceunemploymentthanWhiteIrishor WhiteBritishgroups.Despitesustained,recordlowunemploymentamongthewhitepopulationat 4.4percent,amongblackandAsianpeopleunemploymentistwoandhalftimesgreaterat11.3 percent.Andintermsoftheirearningsfromthelabourmarket,ethnicminorityworkersinBritain areoverrepresentedinlowpayingoccupationssuchasserviceindustries,whichemploy threequartersofethnicminoritymaleemployeesandselfemployedworkcomparedtoaround threefifthsofwhitemen.FiftytwopercentofmaleBangladeshiemployeesandselfemployed workintherestaurantindustry,comparedtoonly1percentofwhitemen.Highproportionsof
141
IndianandPakistaniwomenworkintheretailtrade,anotherlowpayingsector.Occupational segregationisonereasonforpersistentearningsdifferentialsbetweenwhitesandnonwhitesin theUKlabourmarket. EthnicminoritiesfacetwokindsofdiscriminationintheUKlabourmarket: 1. Lessaccesstohigherstatusoccupationsthantheirwhitecounterparts 2. Lowerpayforagivenjob.Thelattereffectisthemorepowerful,accountingforafive percentagepointdifferencebetweenwhiteandethnicminoritywages. Theoryoflabourmarketdiscrimination Wecanmodeltheeffectsofdiscriminationusingasimplelabourdemandandsupplyframework

Wage Wage
Supply
Supply
Wm We Wd We
MRPLWm MRPL MRPLDis Ed Ee Ee Em MRPL
EmploymentofNonWhiteFemales
EmploymentofWhitemales
Ifemployersareprejudicedabouttherelativeproductivityofdifferentgroupsofworkers,thiswillbe reflectedintheirestimatesofthemarginalrevenueproductivityofeachgroup.TheMRPLof discriminatedgroupsislowerthanforothergroups. Itisdifficulttobepreciseabouttheeffectsofdiscriminationinthelabourmarket.Employersrarely havefullinformationabouttheproductivityofalloftheirworkers,letaloneprejudicedorignorant Thisisreflectedinlowerrelativewagesandalowerlevelofemployment viewsabouttherelativemeritsanddemeritsofdifferentgroups.Increasinglyemployers organisationsalongwithtradeunionsareworkinghardtobreakdownbarrierstotheemployment ofdifferentminoritygroupsandinhighlightinginstancesofdiscriminatorybehaviour.Theissueof labourmarketdiscriminationwillremainwithusformanyyears.Itiscloselylinkedtotheissueof labourmigrationandinparticular,therisksofdiscriminationofthemanythousandsofworkers fromEasternEuropewhohavecomeintotheUKeitheronatemporaryorpermanentbasisnow thattwelvecountrieshavejoinedtheEuropeanUnion.
Suggestionsforreadingonlabourmarketdiscriminationandinequality UKgenderequality'longwayoff'(BBCnews,July2007) EUgenderpaygap'notnarrowing'(BBCnews,June2007) Newagediscriminationlawscomeintoforce(BBCnews,July2006) Millionsinwrongjobsayspoll(BBCnews,March2008)

142
27.
TradeUnionsintheLabourMarket
TradeUnions Tradeunionsareorganisationsofworkersthatseekthroughcollectivebargainingwith employerstoprotectandimprovetherealincomesoftheirmembers,providejobsecurity,protect workersagainstunfairdismissalandofferarangeofotherworkrelatedservicesincludingsupport forpeopleclaimingcompensationforinjuriessustainedinajob. o AssociationofFlightAttendants(AFA) o AssociationofTeachersandLecturers(ATL) o Bakers,FoodandAlliedWorkersUnion(BFAWU) o CommunicationWorkersUnion(CWU) o FireBrigadesUnion(FBU) o NationalUnionofJournalists(NUJ) o NationalUnionofTeachers(NUT) o PrisonOfficersAssociation(POA) o ProfessionalFootballersAssociation(PFA) o TransportandGeneralWorkers'Union(T&G) Mainrolesofunions o Improvetherealincomesoftheirmembers o Lobbyforbetterworkingconditionsandpensions o Providejobsecurity o Protecttheirworkersagainstunfairdismissal o Provideacounterbalancetothemonopsonypowerofsomeemployers o Supportpeopleclaimingcompensationforinjuriessustainedinajob o Protectworkersagainstpossibleemploymentrelateddiscrimination UnionMembershipTrends 1. Therehasbeenalongtermdeclineinunionmembership.In2007,lessthan30percentof peopleinajobintheUKweremembersofatradeunion a. OnlyoneinsixprivatesectoremployeesintheUKwereunionmembersin2006 b. AlmostthreeinfivepublicsectoremployeesintheUKwereunionmembers c. Aroundonethirdofworkerssaythattheirpayandconditionsareinfluencedby tradeunioncollectivebargaining d. Thehourlywagesofunionmembersaveraged12.43in2006,16.6%morethan theearningsofnonmembers(10.66perhour). e. Nearly60percentofpeopleworkingineducationaremembersofatradeunionbut only6percentofpeopleinhotelsandrestaurantsandonly11percentofpeople workinginwholesale,retailandmotortrades f. Onlyoneworkerinfiveinmanufacturingindustryisamemberofaunion g. Onlyoneworkerintenagedbetween1624yearsisatradeunionmember 2. Unionsnowhavesignificantlylesspowerandinfluencetodeterminepayandconditions thantwentyyearsagoalthoughinsomeindustries(includingpostalworkers,railway
143
worker,firefightersandprisonofficers)unionsarestillpreparedtoexerttheirindustrial muscle. 3. Undernewlegislation,employersmustrecogniseaunioninpayandemployment discussionswhenamajorityoftheworkforcewanttoberepresentedandhasvotedforit. Butthereislittleevidencethatunionmemberssecureanysignificantwagemarkupor greaterjobprotectionthanpeopleinnonunionjobs 4. Incurrenttimes,employershavelessincentivetofearunions(manyworkinpartnership withbusinesses)butindividualshavelessincentivetobelongsinceinflationislowandthe economyisstrong 5. Thenumberofactivetradesunionshasdeclinedbyover40%between1990and2005 therehavebeenanumberofmergers. Whyhasunionmembershipdeclined? 1. Manypeoplenolongerbelievethatunionmembershipisworththeirwhile a. Lowinflationmeanslesspressureforhigherpaytoprotectrealincomes b. Tougheremploymentlawsmakeitharderforunionstostrike c. Perceptionthattradeunionshavelostsomeoftheirrelevance 2. ChangestothenatureoftheUKlabourmarket a. Increasednumberofpeopleworkingparttimeorflexitime b. Shifttowardsshorteremploymentcontracts c. Declineinthenumberofjobsinheavyindustry(deindustrialisation) 3. Someemployershaveresistedhavingtradeunionsintheirworkplaceorprefertodeal onlywithoneortwounionsonpayandotherissues Tradeunionpower Unionshavelesspowerandinfluenceinthelabourmarketthantheydidtwodecadesago althoughinseveralbigindustriestheycanstillexerttheirindustrialmuscle.Powerhasgradually ebbedawayforavarietyofreasons: 1. Employmentlegislationwhichhasoutlawedillegalstrikes,givenemployerstherightto seekcompensationfortheeffectsofcertainformsofindustrialactionandrequiresall unionstoholdsecretballotsoftheirmembersbeforeanystrikeactionispermitted 2. Theeffectsofincreasedcompetitioninproductmarketsinnearlyeverydomestic marketforgoodsandservices,thereisgreatercompetitionthantherewasafewyearsago. Beittheintensityofglobalcompetitionfromlowercostproducersorthederegulationof marketsthathasincreasedmarketcontestability,tradeunionshavehadtoadjusttoaworld wherethepricingpowerofmanufacturersandserviceindustrieshasbeenseverely curtailed.Hencetheincreasingdemandsfrombusinessestolinkpayandconditionsto workerproductivity.Therearestillsomefairlymilitanttradeunionsaroundnotablyinthe publicsectorservicesincludingtransport.Thetraindriversunion,ASLEF,hasbeenoneof themoremilitantunionsinrecentyears,conductingstrikesontherailnetworkandLondon Underground. 3. Patternsofemployment:Therehasbeenalongtermchangeinthestructureof employmentintheBritisheconomyawayfromtraditionallystrongunionsectorssuchas heavyengineering,coalmining,steelandtextiles,towardsservicesectorjobsintheprivate sectorwhereuniondensityismuchlower Unionsandwagenegotiationslabourmarkettheory
144
Unionsmightseektoexercisetheircollectivebargainingpowerwithemployerstoachievea markuponwagescomparedtothoseonoffertononunionmembers.Forthistohappen,aunion musthavesomecontroloverthelaboursupplyavailabletoanindustry.Inthepastthiswas possibleifaunionoperatedaclosedshopagreementwithanemployeri.e.wherethe employerandunionagreedthatallworkerswouldbeamemberofaparticularunion.Howeverin mostsectors,theclosedshopisnowhistoryoutlawedbylegislation. Morefrequently,aunionmaysimplybidforbetterpaythroughbilateralnegotiationswith employerstoachieveanincreaseinwagesaheadoftherateofinflationsothatrealwagesrise, andotherimprovementstoworkinghoursandconditions. Thebalanceofpowerbetweenemployersandatradeunionintheirperiodicwagenegotiations dependsonarangeoffactorsincluding: 1. Unemployment:whenlabourisscarceandthereareshortagesofskilledworkers,thenthe balanceofpowertiltstowardsunions.Unionsarealwayslesspowerfulwhenthedemand forlabourisfallingandlabourislessscarce. 2. Competitivepressuresinproductmarketswhenafirmisenjoyingadominant monopolypositionandhighlevelsofabnormalprofit,theunionswillknowthattheemployer hasthefinancialresourcestomeetamoregenerouswagesettlement
Elasticlabourdemandunioncontrolof laboursupplyforceswageshigherbut employmentcontracts Inelasticlabourdemandunionsmaybe moreeffectiveinnegotiatinghigherpay levelsandincreasingtotalfactorearnings
Wage Rate
LabourSupply(union controlled) W3
LabourSupply(union controlled)
W2 W1 W1 Labour Supplyto the Economy Labour Demand
Labour Demand
E2 E1
Employment
E2 E1
Employment
Theconventionalcaseagainsttradeunions 1. Unionsactasadistortionintheworkingsofthelabourmarket 2. Theydrivewageshigherandprofits&employmentlowerthanifthelabourmarketwasfully competitive

145
3. Theymaypreventtheintroductionofnew,flexibleworkpractices 4. Theymaydelaytheintroductionofnewtechnologywhichthusaffectsproductivity 5. Theircollectivebargainingpowercanleadtohigherwagesandcostpushinflationary pressureswhichleadstoaworseningofmacroeconomicperformance 6. Unionscancauselabourmarketfailuresuchasrealwageunemployment Counterarguments 1. Thenewpartnershipmodelbetweenemployersandunions a. Unionsandtheirmembersstandtogainfrom i. Higherproductivity ii. Theworkforcehavingmoreflexibleskills iii. Improvedworkingconditionsandemploymentrights 2. Higherpaydoesnotautomaticallyleadtofewerjobs i. Monopsonyargument(seepreviouspage) ii. Higherpaycancreateincentivesforhigherproductivityandworkingmore hours 3. Keynesianeffectsofincreasedincomesonconsumerdemandforgoodsandservices risingaggregatedemandleadingtoaboosttoshortruneconomicgrowth 4. Tradeunionshavemodernisedtoreflectchangesinthedomesticandglobaleconomy 5. Theirroleisbecomingevermoreimportant a. Threatstothestabilityandfutureofoccupationalpensions b. Persistentdiscriminationinthelabourmarket(genderglassceilings,age,ethnicity) 6. Theycanworkwithmanagementandemployerstoimproveefficiencyand competitivenessandthereforeachieveapositivesumgame 7. TherehasbeenastepchangeinindustrialrelationsintheUKwhichhasmadetheUK economyafavouredvenueforinflowsofforeigndirectinvestmenttherearefarfewer industrialstoppagesanddayslostfromstrikeaction(seethechartbelow) Suggestionsforfurtherreadingontradeunionsinthelabourmarket Guardianspecialreportsontradeunions
146
28.
TheDistributionofIncomeandWealth
InthischapterweconsiderthescaleofincomeandwealthinequalitiesintheUK.Whydoes inequalityhappen?Andwhatpolicieshavebeenappliedtoaffectthefinaldistributionofincome? IncomeandWealth o Incomeisaflowoffactorincomessuchaswagesandearningsfromworkrentfromthe ownershipoflandandinterest&dividendsfromsavingsandtheownershipofshares o Wealthisastockoffinancialandrealassetssuchasproperty,savingsinbankand buildingsocietyaccounts,ownershipoflandandrightstoprivatepensions,equities,bonds etc Absolutepoverty Absolutepovertymeasuresthenumberofpeoplelivingbelowacertainincomethresholdorthe numberofhouseholdsunabletoaffordcertainbasicgoodsandservices.Whatwechooseto includeinabasicacceptablestandardoflivingisnaturallyopentodiscussion. Relativepoverty Relativepovertymeasurestheextenttowhichahouseholdsfinancialresourcesfallsbelowan averageincomelevel.Theofficialpovertylineisdrawnatanincomeof60%ofthemedianlevel. Althoughlivingstandardsandrealincomeshavegrownbecauseofhigheremploymentand sustainedeconomicgrowth,thereislittledoubtthatBritainhasbecomeamoreunequalsociety overthelast2025years. MeasuringinequalitytheLorenzCurveandtheGiniCoefficient WemeasurethedistributionofincomeandwealthbyusingconceptssuchastheLorenzCurve andtheGiniCoefficient.
THELORENZCURVE
100% Lineofperfectequality
ThefurthertheLorenzcurveliesbelow thelineofequality,themoreunequalis thedistributionofincome.Thereare problemswiththeLorenzcurve particularifweareinaccurateinour measureofincomes. TheGiniCoefficientisderivedfromthe sameinformationusedtocreateaLorenz Curve.TheGiniCoefficientcantake valuesfrom0to100percentwherea valueofzerowouldindicatethateach householdhadanequalshareofincome, whilehighervaluesindicategreater inequality.
Thechartbelowshowsthetrendinthe GiniCoefficientfororiginaland disposableincomesofUKhouseholds sincethelate1970s.Inequalityof disposableincomewasfairlystableinthefirsthalfofthe1980sthenincreasedduringthesecond halfofthe1980s.Inequalitywasrelativelyflatinthe1990sbutwithsomeindicationsofaslightfall inthefirsthalfofthe1990sandaslightrisesincethen.In200102,theGinicoefficientwasbackto its1990level.

Poorest 20% Middle 20% Distributionofhouseholds Richest 20%
%ofincomecumulative
50%
0%
147
PercentagesharesofhouseholdincomeandGinicoefficients,2005 Quintilegroup(20%) Bottom 2nd 3rd 4th Top Allhouseholds Decilegroup Bottomdecile(poorest10%) Topdecile(richest10%) Ginicoefficient (percent)(Maxpossibleis100%) Inequalityoforiginalincome(beforetakingaccountoftaxesandbenefits)hasfollowedadifferent pattern.Itrosefairlysteadilythroughoutthe1980sandhasbeenrelativelystablesincethen.The GiniCoefficientfordisposableincomeislowerthanfororiginalincomebecauseofthe equalisingeffectsofourprogressivetaxandbenefitssystem. Thedistributionofwealth Thedistributionofwealthismoreunequalthanthedistributionofincome.Thelatestfiguresforthe UKarethatover90%ofmarketablewealthisinthehandsofjusthalfthepopulationandovera fifthofwealthisconcentratedamongtherichestonepercentofhouseholds.Lookingatglobal inequalitiesinwealth,astudyfromtheUnitedNationsWorldDevelopmentReportpublishedin November2006foundthattherichest2%ofadultsintheworldownmorethanhalfofall householdwealth.Accordingtothereport,WealthisheavilyconcentratedinNorthAmerica, EuropeandsomecountriesintheAsiaPacificregion,suchasJapanandAustralia. ExplainingthescaleofincomeandwealthinequalityintheUK Proportionofpeoplewhoseincomeisbelowvariousfractionsofmedianhousehold disposableincome <60%ofmedianincome <50%ofmedianincome 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:SocialTrends36
Percentagesharesofincome Original income 3 8 15 24 50 100 1 32 51 36 3 27 32 100 3 26 36 7 11 16 23 43 100 2 27 Gross income 8 13 17 22 41 100 Disposable income 7 12 16 22 43 Posttax income
148
Therearenumerousexplanationsbothfortheexistenceandpersistenceofahugedividein incomesandwealthwithintheUK.Mostofthemareeconomicinorigin,butsomearelinkedto socialchange. Asummaryisprovidedbelow: (1)Differencesinpayindifferentjobsandindustries Highgrowthindustrieshaveenjoyedaboveaverageincreasesinpayandearnings.Theseinclude (untilrecently)financialandbusinessservicesandinformationtechnology.Jobswherelabour demandishighandthereareshortagesofskilledlabourtendtooffermoregenerouspay packagesforemployees.Incontrast,publicsectorservicejobshaveseenadeclineinrelativepay levelsbecausepayinprivatesectorjobshastendedtooutstripearningsgrowth. Theworstpaidjobsarestillfoundinlowerskillservicesectorindustriesoftenwherethereislittle tradeunionprotectionandwherejobinsecurityisendemic. (2)Fallingrelativeincomesofpeopledependentonstatebenefits Statewelfarebenefitsnormallyriseinlinewithretailprices(theyareindexlinked)ratherthanwith earnings.Therefore,householdsdependentonwelfareassistanceseetheirrelativeincomesfall overtime.Thisisaparticularproblemformanythousandsofpensionerhouseholdsandalsofor largefamiliesonlowincomessinceforbothgroupsitiswidelyrecognisedthattheinflationthat theyhaveexperiencedhasbeenwellabovethenationalfigureforconsumerpriceinflation.Not onlyhavetheyfallenbehindinrelativetermsbuttheirrealincomeshavetakenahitfromthe sharpsurgesinfoodandutilitybillsoverthelasttwoorthreeyears. (3)Theeffectsofunemployment Unemploymentisakeycauseofrelativepoverty(i.e.anincreaseinincomeinequality).For example,aseriousproblemistheincreaseinthenumberofhouseholdswherenooneisinpaid employmentandwhereafamilyisdependentonstatewelfareaid.Pocketsofhighlongterm unemploymentarenearlyalwaysassociatedwithanincreasedriskofpoverty.Londonisagood exampleofthishugewealthanddeeppovertyfrequentlylivecheekbyjowl. (4)Changestothetaxandbenefitsystem Changestodirectandindirecttaxeshavecontributedtoanincreaseinrelativepoverty.Incometax rateshavefallenoverthelasttwodecades.Thetopmarginalrateoftaxfellfrom83%in1979to 40%in1988whereithasremained.Thebasicratehascomedownfrom33%in1979to22% today.Thesetaxreductionsallowpeopleinworktokeepahigherproportionoftheirearned income.Thebenefitsfromlowertaxeshavefloweddisproportionatelytopeopleonaboveaverage incomesbecauseofafallintheprogressivenatureoftheUKsdirecttaxsystem. Therehasbeenaswitchtowardsindirecttaxesinrecentyearsincludinghigherratesofvalue addedtaxandhigherexcisedutiesonpetrol,alcoholandcigarettes.Someoftheseindirecttaxes havearegressiveeffectonthedistributionofincome.Agoodexampleofthishasbeenthereal termincreaseinthelevelofexcisedutyoncigarettesandtheproposedrisesinvehicleexcise duty. Policyoptionstochangethedistributionofincomeandwealth Therearemanypolicyoptionsavailabletoagovernmentifitwantstochangethefinaldistribution ofincomeandwealthinacountry.ThemainstrategiesthattheLabourgovernmenthaschosento reducepovertysinceitwaselectedinMay1997. o TheintroductionofaNationalMinimumWageandaseriesofincreasesinitsvalue o ThelaunchoftheWorkingTaxCreditandChildTaxCreditdesignedtoboostwork incentivesforlowincomehouseholdswhoopttoworkfulltimeorparttime
149
o ProvisionofaMinimumIncomeGuaranteeforPensionersandincreasesinthereal valueofWinterFuelPaymentsdesignedtoalleviatefuelpovertyamongoldpeople o ActiveemploymentpoliciessuchastheintroductionofNewDealsforyoungpeople,the longtermunemployed,loneparentsanddisabledpeoplealongtermstrategydesigned toincreaseemploymentopportunities Inadditionthegovernmentalreadyhasinplaceaprogressivesystemofincometaxandwelfare benefitsthathelpstoreducethehugedifferencesbetweenoriginalandfinaldisposableincomes betweendifferentgroupsofthepopulation. Incomeredistributionthroughthetaxandbenefitsystem WhataretheeffectsofthetaxandbenefitsystemonthefinaldistributionofincomeintheUK? ThissummarytableispublishedeachyearbytheGovernmentandgivesusanideaofthe progressivenessofthetaxandbenefitssystemforhouseholdsindifferentincomebands Originalincomecomesfromwagesandsalariesinwork,selfemploymentincome,investment incomesetal.Towhichweaddentitlementstowelfarebenefitsincashnotthatthelowest incomehouseholdsarethosemostentitledtothesebenefits,someofwhicharemeanstested. Theratiooftheoriginalincomeoftherichestfifthofhouseholdstothepoorestfifthis18.Bythe timethatgovernmentwelfarebenefitshavebeenincluded,thatratiofallsto7.1. Thenweincludetheeffectsofdirecttaxationmainlyincometaxandnationalinsurance whichactsasaprogressiveformoftaxationahigherincomegrouppaysahigher%oftheir incomesintax.Thisgivesusdisposableincometheratioofthedisposableincomeofthe richestfifthofhouseholdstothepoorestfifthis6.1. Ourfinaltransferistoincludetheeffectsofindirecttaxesandestimatedbenefitsinkindfromstate provisionofeducation,theNHSandhousingsubsidiestogiveafigureforfinalincome.Thefinal resultisthatourratiobetweenrichestandpoorestquintilesfallsfurtherto4.2. Indirecttaxesfallmostheavilyonpooresthouseholds.In200102,theyaccountedfor34%of disposableincomewhereasforthehighestincomequintile,thepercentagewasjust14%.This suggeststhatindirecttaxationoverallhasaregressiveeffectonthedistributionofincomeinthe UK. Thegovernmenthasfocuseditspoliciesinthefollowingareas o Promotinghigherlevelsofemployment o Attemptingtoreducetheskillsgapexistinginthelabourmarketworkerswithlowgrade skillsaresufferingbadlyintodayseverchanginglabourmarket o Switchingtowardsmeanstestedbenefitsratherthanuniversalbenefits o Offeringspecificfinancialhelptocertaingroups o Improvingworkincentivesforthelowpaid
150
UKMinimumWageAdultRate (forworkersaged22+) 1Apr1999 1Oct2000 1Oct2001 1Oct2002 1Oct2003 1Oct2004 1Oct2005 1Oct2006 1Oct2007 1Oct2008 Therehasbeensomelimitedprogressinattackingsomeofthecausesofpoverty.Forexamplethe numberofchildrenlivinginpoorhouseholdsfellby200,000in200203.Butthelatestofficial figuresfortheUKshowthatincomeinequalityremainsgreaterunderLabourthanunderthe1979 97ConservativegovernmentsofMargaretThatcherandJohnMajor. TheMinimumWage Theminimumwageisapriceflooremployerscannotlegallyundercutthecurrentminimum wagerateperhour.Thisappliesbothtofulltimeandparttimeworkers.Laboursupplyand demandcurveanalysiscanbeusedtoshowtheeffects. Evidenceontheminimumwagehasitworked? 1. Employment:Sincetheminimumwagewasintroduced,unemploymentinBritainhas fallenandthelevelofemploymentintheBritisheconomyisnowatarecordhighalthough theeconomyhasavoidedarecessionthroughoutthisperiod. 2. Inflation:Inmanysectorsfirmsfindithardtopassonhigherwagecoststofinal consumerslimitingtheinflationaryeffectoftheminimumwage 3. Wagecosts:Theminimumwageaffectsonlyasmallproportionofworkersandtheeffects onthewagebillsofmostbusinessesisnotasignificantfactorintheiremployment decisions.Intheshortterm,thedemandforlabourtendstobeinelasticwithrespectto changesinwages 4. Discrimination:Theminimumwagehashadanimpactontheearningsofparttimefemale workers. 5. Productivity:Itishardtoidentifyanystrongpositiveeffectonlabourproductivitybut efficiencygainshavebeenmadeinmostlowpayingindustries,atrendwhichstarted beforetheminimumwagewasintroduced. Whichpoliciesaremosteffectiveinreducingpoverty? Agovernmenttrulycommittedtomakingaseriousdentinrelativepovertywould o Investmoreresourcesinskillstrainingandlifelongeducationforallhouseholds particularlythoseoflowincomefamiliesinabidtomakearealeffectonchildpoverty o Makingthetaxsystemmoreprogressiveforexampleraisingthehigherrateoftax from40%forthetopearninghouseholds
3.60 3.70 4.10 4.20 4.50 4.85 5.05 5.35 5.52 5.73
151
o AnalysingcarefullytheeffectsofchangesinindirecttaxessuchasVATandexciseduty incasetheyhavearegressiveeffectontheoveralldistributionofincome o Focusmoreontargetingbenefitsbymeanstestingthemaccordingtofinancialneed o Increasethevalueofwelfarebenefits/taxcreditsinlinewiththeannualpercentage growthinmedianearningssothattherelativevalueofthesebenefitsdoesnotdecline Incometaxpayable:byannualincome,in2006 Number of taxpayers (millions) 0.1 2.9 3.5 6.1 5.1 6.4 4.3 1.5 0.5 30.5
4,8954,999 5,0007,499 7,5009,999 10,00014,999 15,00019,999 20,00029,999 30,00049,999 50,00099,999 100,000andover Allincomes Earningenoughtolive
Total Average Average tax rateoftax amount liability (percentages) oftax () ( million) 0.1 1 5 2.0 369 126 5.1 1,580 445 9.8 7,560 1,220 13.0 11,500 2,260 15.4 24,000 3,760 17.9 28,900 6,690 25.7 17,000 25,900 33.4 71,100 34,200 18.2 134,000 4,390
AccordingtoareportfromtheJosephRowntreeFoundationAccordingtomembersofthepublic, asinglepersoninBritaintodayneedstoearnatleast13,400ayearbeforetaxtoaffordabasic butacceptablestandardofliving.Theminimumincomeisabovetheofficialpovertylineof60% medianincome,fornearlyallhouseholdgroups.Thisshowsthatalmosteverybodyclassifiedas beinginpovertyhasincometoolowtopayforastandardoflivingregardedasadequatebyall membersofthepublicwhotookpartinthisresearch. Accordingtothereport: AminimumstandardoflivinginBritaintodayincludes,butismorethanjust,food,clothesand shelter.Itisabouthavingwhatyouneedinordertohavetheopportunitiesandchoicesnecessary toparticipateinsociety.Theminimumseekstoexcludeitemsthatmayberegardedas aspirationalitisaboutfulfillingneedsandnotwants. Source:Tutor2ublog,July2008 Takingthelongview Nopoliciestorelievepovertyareriskfree.Manyarehighlyexpensiveandtheireffectsoftentake manyyearstoshowthroughproperly.Theconsensusamongtheleadingacademicresearchersis thathighemployment,andacommitmenttoraisetheskillsandpotentialearningsofpeople towardsthebottomofthepayladderarethemosteffectiveandsustainablepoliciesinthelong term. FurtherbackgroundreadingonpovertyandinequalityintheUK Atlast,asensiblewaytomeasurepoverty(TimHarford,FinancialTimes,July2008) Butcherguiltyoflowstaffwages(BBCnews,July2008) DividedBritainneedsnewladderofopportunity(TheTimes,April2008)
152
HardRockwagesbelowtheminimum(BBCnews,July2008) Howthesuperrichjustgotricher(MoneyProgramme,November2007) It'sarichcitybutithas650,000poorchildren.It'sLondon(TheTimes,April2008) Japansetsupminimumwageraise(BBCnews,April2007) Livingontheminimumwage(BBCnewsaudiovisual,2006) MindtheGap(Guardian,January2008) Minimumwageriseof3.8%stokesunionanger(TheTimes,March2008) Thechangingfaceofpoverty(BBC)
153
29.
MarketFailureExternalities
Inthischapterwelookattheeconomicsofexternalitiesandpolicyapproachestocontrollingand correctingforexternalitieswithaparticularfocusonenvironmentalpolicies.Externalitiesare commoneverywhereineverydaylifebutwillthemarketlefttoitsowndevicestakethese externalitiesintoaccount?Ifnot,thenmarketfailurecanoccurandthereisajustificationforsome formofgovernmentintervention. Economicimportanceoftheenvironment Theenvironmentplaysanessentialroleinshapingoureconomicandsocialwelfare.The environment 1. Providesservicestoconsumersintheformoflivingandrecreationalspacesandthe opportunitytoenjoyutilityfromexperiencingnaturallandscapesandhabitats. 2. Itprovidesuswiththenaturalresourcesnecessarytosustainproductionand consumptionincludingthebasisforrenewableandnonrenewablesourcesofenergy. 3. Itisadumpinggroundforthewasteproductsofoursocietybeitwastefrom producersorfromhouseholdsandconsumers. Thelinkbetweeneconomicactivityandourenvironmentisfundamental.Wehearconstantlyabout theneedforsustainablewelfare,forgrowthtotakeintoaccountthedirectandindirecteffectson ourresources.Andincreasinglywe,asproducersandconsumers,areaffectedbygovernment policiesandstrategiesdesignedtopromoteenvironmentalprotectionandimprovement. Sustainabledevelopmentisthatwhichmeetstheneedsofthepresentwithoutcompromisingthe abilityoffuturegenerationstomeettheirownneeds. Externalitiesandtheenvironmentthebasics Forenvironmentaleconomics,oneofthemostimportantmarketfailuresiscausedbynegative externalitiesarisingfromproductionand/orconsumptionofgoodsandservices. Externalitiesarethirdpartyeffects arisingfromproductionandconsumption ofgoodsandservicesforwhichno appropriatecompensationispaid.An importantpointtoemphasiseisthat externalitiesoccuroutsideofthe marketi.e.theyaffectpeoplenotdirectly involvedintheproductionand/or consumptionofagoodorservice.They arealsoknownasspillovereffects. Oneofthemajorproblemsfacingthe environmentisthatcommonresources suchasfishstocksandgrazinglandare notprivatelyownedcommonlyowned resourcesmaylacktheprotectionofpropertyrightsandaresusceptibletooverexploitation becausethemarginalcostofextractingtheresourceforaprivateagentisclosetozero.Thisis knownasthetragedyofthecommons. Whenthereareenvironmentalexternalities,theprivateequilibriumpriceandquantity determinedbytheinteractionofmarketsupplyanddemandisnotthesameasthesocial equilibriumwhichincludesallinternalandexternalcosts.Forexample,inafreemarket,aproducer willhavelittledirectincentivetocontrolpollutionbecauseitisexternali.e.theprofitmaximising supplierconsidersonlyhis/herownprivatecostsandbenefits.Themarketfailurearisingfrom negativeexternalitiesisshowninthediagrambelow.Thearealabelledabcisthedeadweightloss
154
ofwelfareduetooutputbeingabovethesocialoptimum.AtoutputlevelsbeyondQ2,themarginal socialcostexceedsthemarginalsocialbenefitcausingoverallwelfaretodrop.
Benefits Costs Social Equilibrium a c P1 b Private Equilibrium MarginalSocialCost MarginalPrivateCost
Demand(MarginalPrivateBenefit)= Deadweightlossof economicwelfare MarginalSocialBenefit
Q2
Q1
QuantityofOutput(Q)
Economistsarguethatmarketfailuresprovideaclearrationaleforpolicyinterventionto improveefficiency.Butsincemarketfailuresarepervasive,interventionisonlyjustifiedifthe benefitsexceedthecosts.Asweshallsee,reducingpollutionisrarely,ifever,acostfree process. TheTragedyoftheCommons Thecontributionofeacheconomicagentisminute,butsummedoverallagents,theseactions degradetheresourceandmaycauseseverelongtermdamage Thetragedyofthecommonsisametaphorusedtoillustratethepotentialconflictbetween individualselfinterestofproducersandconsumersversusthecommonorpublicgood. Intheoriginalversionoftheterm,theexampleisusedofastockofcommongrazinglandused byalllivestockfarmersinasmallvillage.Eachfarmerkeepsaddingmorelivestocktograzeonthe commons,becausethemarginalcostofdoingsoiszero.Butbecausethecommonlyowned resourceisthusoverexploited,theresultisadepletionofthesoilandafallinthevalueofthe resourceforallusers.Theresourcemaybecomeirretrievablydamaged,anexampleofapublic bad. Therootcauseofanytragedyofthecommonsisthatwhenindividualsuseapublicgood,theydo notbeartheentiresocialcostoftheiractions.Ifeachseekstomaximizeindividualbenefit,heor sheignorestheexternalcostsbornebyothers.Theabsenceofwelldefinedandlegallyprotected propertyrightsliesattheheartoftheproblem. Atragedyofthecommonscanoccurevenwithoutcompleteandpermanentdestructionofa resourcethetermcanbeusedtodescribeanysituationwherewhatwasperceivedasa renewableresourcebecomeslessvaluablebecauseofoverexploitation. Goodexamplesofthetragedyofthecommons Burningoffossilfuelscarbonemissionscontributingtoglobalwarming
155
Pollutionofwaterwayscreatingotherexternalitiesforusersofwaterwaysfurther downstream Loggingofforestse.g.thelongtermimpactontheBrazilianrainforestandtheeffectsof illegallogging Overfishingoftheoceanse.g.thecurrentcrisisintheEUfishingindustry Flytippingofwasteproductsonpublicland Gametheoryandthetragedyofthecommons Thetragedyofthecommonscanbelinkedtotheprisoner'sdilemmathatisanimportantpart ofgametheory.Individualswithinagrouphavetwooptions:cooperatewiththegroupordefect fromthegroup.Cooperationhappenswhenindividualsagreetoprotectacommonresource. Defectionhappenswhenanindividualdecidestousemorethanhisshareofapublicresource. Cooperationhasthepotentialtomaximizeeveryindividual'sbenefitinthelongrunasthe commonsarepreservedandcanbeusedindefinitely,whiledefectionmaximizesanindividual's benefitintheshortrunattheexpenseofdestroyingitinthelongrun.Thusinthecaseoffish stocks,suppliersneedtocooperateoveraperiodoftimesothatfishstockscanstarttoriseagain. ThisistheessenceofattemptstoreformtheEuropeanUnionCommonFisheriesPolicy. Analternativetoregulationandtaxationbygovernmentistocreateamarketinpropertyrightsin ordertocontroltheimpactofeconomicactivityontheenvironmentforexampleestablishinga carbontradingemissionsschemeorintroductiontradablefishingpermitsfortheEUfishing industry. TheEconomicsofWaste Wasteisaninevitablebyproductofproductionandconsumption.Buttheeconomicsofwasteis nowahugeeconomicaswellassocialissue.TheUKgovernmentwantsmorewastebeing disposedofthroughincinerationratherthandumpedinlandfillsites.Ithasrestateditsstrategy andatthetopofthewastehierarchyistheaimofreducinghowmuchwasteiscreatedinthefirst placeandtherebyachieveadecouplingofwastegenerationfromrisingeconomicactivity. Becausewasteisnormallyregardedasademeritgoodcreatingexternalcosts,thereis justificationforsomeformofgovernmentinterventiontochangemarketprices,alterincentivesand causeachangeinthebehaviourofconsumersandproducers. Governmentpolicyneedstobemoreeffectiveinenhancingtheincentivesforindividualsand businessestorecyclemoreoftheirwasteproducts.

156
Hierarchyofprinciplesofwastemanagement: o Preventionofwastereducetheamountofwastecreatedinthefirstplace o Reusetheproduct o Recycleorcomposttheproduct o Recovertheenergybyincinerating o Disposaloftheproductusinglandfill Governmentinterventiontoreducemarketfailurefromnegativeexternalities Traditionally,policytowardstheenvironmenthasconcentratedintwomainareas 1. Interventioninthepricemechanismforexampleenvironmentaltaxesandsubsidies 2. Commandandcontrolmeasuresforexamplethroughregulationsanddirectives Thesepoliciesaredesignedto: o Achieveamoreefficientuseofresources. o Promotesubstitutionbetweenresources(e.g.abundantforscarce,renewablefornon renewable). o Provideincentivesforloweremissionsorachangefromharmfultobenignemissions. Environmentaltaxation In2008EconomistRobertFrankwrotethatWhenmarketpricesconveyaccuratesignalsofcost andvalue,theinvisiblehandpromotesthecommongood.Butpricesoftendivergefromcostand valueand,inthosecases,taxescanactuallyhelpsteerresourcestowardmorehighlyvalued uses. Anenvironmentaltaxisataxonagoodorservice whichisjudgedtobedetrimentaltothe environment.Itmayalsobeataxonafactorinput usedtoproduce(supply)thatfinalproduct.The mainaimofgreentaxationisto (i) Increasetheprivatecostofproducing goodsandservicessothatthe producer/consumerispayingforsome ofthenegativeexternalitiesthattheir actionsarecreating(i.e.the externalityisinternalised)this promotesallocativeefficiency.
(ii) (iii) (iv)
Raisethefinalcost/priceoftheproductsothatdemandcontractsthereisnormallya directlinkbetweenthelevelofoutput/consumptionandthetotalpollutioncreated. Reduceoutputlevelstowardstheestimatedsocialoptimumlevelofproduction. Welldesignedenvironmentaltaxescanencourageinnovationandthedevelopment ofnewtechnologieswhichreducesourdependencyonpollutioninefficientformsof energy.Thiscanhelptopromotedynamicefficiency.
157
(v)
Revenuederivedfromthesetaxescanbeearmarkedforlowertaxeselsewhereinthe economysothatanewenvironmentaltaxisrevenueneutralortofundincreased spendingonenvironmentalprojects. Intergenerationalequityjustification:Achievingimprovedsustainabilityinour resourceusenowhelpstoprotecttheresourcesavailableforfuturegenerations.
(vi)
Examplesofenvironmentaltaxesinclude:fuelduty,vehicleexciseduty,airpassengerduty,the aggregatestax,thelandfilltaxandtheLondonCongestionCharge.TheIrishGovernmentalso introducedataxonplasticbagsinabidtoreduceconsumptionandencouragerecycling.The mainaimofanenvironmentaltaxistoincreasethefirmsprivatemarginalcost(PMC)untilit equateswiththesocialmarginalcostcurve(SMC). Problemswithenvironmentaltaxation Thereisagrowingbodyofeconomistswhoarguethat relianceonenvironmentaltaxationisanineffectiveway ofpromotingenvironmentalimprovement,indeedthat sometaxesarepronetogovernmentfailure.And,that therearewaysofchangingtheincentivesofproducers andconsumersthroughthemarketmechanism. Themaincriticismsofenvironmentaltaxesarediscussed below: 1. Valuingtheenvironment:Thereare fundamentalproblemsinsettingtaxessothat marginalprivatecostswillequatewiththe marginalsocialcosts.Thegovernmentcannot accuratelyvaluetheprivatebenefitsandcostof businessesletaloneputamonetaryvalueon externalitiessuchasthecosttonaturalhabitat,thelongtermeffectsofresourcedepletion andthevalueofhumanlife.Frequentadjustmentsoftaxlevelsmayberequiredandthis involvessubstantialorganisationalcosts. 2. Consumerwelfareeffects:Taxesreduceoutputandraiseprices,andthismighthavean adverseeffectonconsumerwelfare.Producersmaybeabletopassonthetaxtothe consumersifthedemandforthegoodisinelasticand,asresult,thetaxmayonlyhavea marginaleffectinreducingdemandandfinaloutput. 3. Achievingatargetquantityofpollutionreduction:Taxesdonotlendthemselvestothe governmentachievinganaccuratereductionintotalpollution.Thisisbecauseno governmentcaneverpredicthowconsumersandorproducerswillrespondtohighercosts andprices.Thepriceelasticityofdemandwillvaryovertime. 4. Incomedistribution:Taxesonsomedemeritgoods(forexamplecigarettes)mayhavea regressiveeffectonlowincomeconsumersandleadtogreaterinequalitiesinthe distributionofincome.Havingsaidthis,itshouldbepossibleforauthoritiestodevelop smarttariffsortaxeswhereaccountistakenoftheimpactofpollutiontaxesonvulnerable householdssuchaslowlowincomeconsumers.ThecurrentLabourgovernmenthas reducedtherateofVATondomesticfueltotheEUminimumrateof5%,butthe governmenthasnoplanstointroduceadomesticenergytaxbecauseofthehugenumbers oflowincomehouseholdsthatcurrentlyliveinfuelpoverty.IntheUK,thepoorest10%of householdsspends13.2%ofincomeonenergywhereastherichestspends3.5%. 5. Employmentandinvestmentconsequences:Ifpollutiontaxesareraisedinonecountry, producersmayshiftproductiontocountrieswithlowertaxes.Thiswillnotreduceglobal pollution,andmaycreateproblemssuchasstructuralunemploymentandalossof
158
internationalcompetitiveness.Similarly,highertaxationmightleadtoadeclineinprofits andafallinthevolumeofinvestmentprojectsthatinthelongtermmighthavebeneficial spillovereffectsinreducingtheenergyintensityofanindustryormightleadtoinnovation whichenhancetheenvironment 6. Moreefficientalternatives?Itmightbemorecosteffectiveforgovernmentstoswitch awayfrompollutiontaxationtodirectsubsidiestoencouragegreaterinnovationin designingcleanerproductiontechnologies.Ecotaxreformersoftenarguethatpollution taxesshouldberevenueneutralsoforexample,anincreaseinenvironmentaltaxation mightbeaccompaniedbyreductionsinemploymenttaxessuchasNationalInsurance Contributionssothattheemploymentconsequencesofhighertaxationareminimised.The impactofgreentaxesdependscruciallyonwhatisdonewiththerevenues.Iftheyare balancedbyreducingothertaxesthroughrevenuerecycling,researchsuggeststhat greentaxescouldresultinanoveralleconomicimprovement Suggestionsforfurtherreadingonexternalitiesandgovernmentintervention Amazonburnsonceagain(Guardian,October2007) Dosmokeanddrinktaxriseswork?(BBCnews,March2008) Gagguzzlerstoface950tax(BBCnews,March2008) Payingforenvironmentaldamage(BBCnews,June2007) PetroltaxesPigouorNoPigou?(Economist,November2006) Scrutinisingclimateeconomics(BBC,January2007) Taxingtimetostabilisetheclimate(BBCnews,June2008) UnsustainableWorld(BBCNewsnightspecialreports,Spring2008) UScitytostartchargingpollutingfirms(BBCnews,May2008)
159
30.
CarbonEmissionsTradingandtheSternReview
Emissiontradingisregardedbymanyasthefutureofenvironmentalprotectionandimprovement intheUK,Europeanandinternationaleconomy.Carbontradingisanotherformofpollutioncontrol thatusesthemarketmechanismtochangerelativepricesandtheincentivesofproducersand consumers.Thereisalsogrowinginterestintheideaofpersonalcarbontrading,theUK governmentiscurrentlylookingattheissue. Thebasicsofcapandtradeemissionstrading 1. Afixednumberofemissionpermitsisallocatedeachyeartopollutingfactories 2. Usualdenomination:1permit=1tonne(e.g.ofCO2emissions) 3. Totalnumberofpermitsisthelimitonpollutionthecap 4. Annualemissionsofeachfactorymustbelessthanorequaltopermitholdings 5. Permitscanbetradedi.e.capandtrade 6. Factorieswhichcanreduce(abate)pollutionforlessthanthepriceofapermitcansell spareonesforaprofit 7. Factorieswhichfinditmoreexpensivetoreducepollutioncanbuyextrapermitsinstead 8. Graduallythesupplyofpermitsisreducedthemarketpricerises.Thisgivesfirmswho finditexpensivetocutpollution,moreofanincentivetoseeknewtechnologies/process thatwillreducetheirpollutionemissions Amarketablepollutionpermitgivesabusiness therighttoemitagivenvolumeofwasteor pollutionintotheenvironment.Ideally,thenumber ofpermitsthatareissuedcorrespondswiththe totallevelofpollutionthatisadmissibleatthe socialoptimumlevelofoutputi.e.wheretheMSB =MSC.Oncethishasbeendeterminedthe permitsareissuedbyauctionandfirmsthat pollutetheenvironmentcanbidforthemandthen buyandsellthemamongstthemselves. Pollutionpermitsshould,intheory,givefirmsan incentivetocontrolpollutionemissionsforless thanitwouldcosttobuypermits,andthereis evidencefromcapandtradepollutionpermit schemesintheUKandtheUnitedStatesthatthe costsofmonitoringpollutionreductionand administrationofthepermitssystemissmallerthanwhenanindustryissubjecttodirectregulation. IntheUnitedStatescapandtradescheme,itwasfoundthatmanyhighpollutingbusinesses investedinfittingnewpollutioncontrolequipment(e.g.FlueGasDesulphurisation)andother pollutersswitchedfromhightolowsulphurcoal. Consequentlytheuseofmarketablepermitsallowsthecostofpollutioncontroltobeminimised. Anotheradvantageisthattherevenuefromatradedpollutionpermitsschemecanberecycled intootherschemesforenvironmentalimprovement. IncentivesmattercreateamarketintherighttopolluteThebasicideabehindtraded pollutionpermitsistothroughtheincentivetocutpollutiondirectlytotheproducersthemselves. Companiescanthenmaketheirowndecisionsaboutthecostsandbenefitstothemofparticular
160
routestoemissionreductions.Inotherwords,marketforcesarebroughttobearontheissueof pollutionandpotentialmarketfailure. Emissiontradingislikelytobemosteffectivewhen 1. Thereisaneasilymeasurablepollutant 2. Thegovernmentsetsaclearlydefinedandstableemissionstarget 3. Therearealargenumberofparticipantfirms,withcompaniessufficientlysophisticatedto dealwiththetechnicalitiesoftradingatauction 4. Widevariationincostsofreducingpollutionsothattradingofsurpluspermitscantake place 5. Thetransactionscostsoftradingpermitsarelowandthereisclearpollutiondata availabilityatthestartandduringtrading 6. Strictenforcementofpermits(i.e.ahighcompliancerateamongparticipatingbusinesses) Carbontradingandgovernmentfailure TheEU'sflagshipcarbontradingschememaybefailingtoachievetheobjectivessetforit.Coal productionisontheincreaseintheUKandaroundEurope.Butthisisthesortofthingthatisn't supposedtobehappening!Evenwiththepotentialforcleancoaltechnology,itiswidelyregarded asadirtysourceofenergyandamajorcontributortoC02emissions.Whyarethepowerstations turningbacktocoal?Becausethepriceofcarbonemissionsislowandcoalhasbecomeprice competitiveagainstoilandgas. Europe'scarbontradingschemestartedinJanuary2005withcarbonallowancesbeingboughtand sold.ThelargestC02emitterswerebroughtintothecapandtradesystem.Thecapplacesalimit onthetotalpotofemissionsthatcanbereleasedbyindustrytheaimistoprogressivelyreduce thiscapovertimeandthereforemitigateclimatechange.TheoriginalcapssetbytheEUarenow seenasbeingsetwaytoohighandsomepeoplebelievethatthiswasnotanaccident,companies andbusinessesmayhavebeendeliberatelygivenmoreallowancesthantheyneeded,creating surpluspermitsthatcouldbeprofitablysoldontotootherbusinesses. CarbonTradeWatchbelievethattheEUhasbeencapturedbystrongcorporatelobbyingwho themselvesknowinglyoverestimatedtheir"businessasusual"C02emissionswhenthey submittedthemtonationalgovernmentsaheadofthelaunchofthecarbontradingscheme.The surplusofC02emissionallowanceshasmeantthatscarcityinthemarkethasdisappearedleading toacollapseinthepriceofcarbonpricesnoware2030Eurocents,effectivelythepriceof pollutingisclosetozero.Themarketthusprovideslittleincentiveforbusinessestoinvestmoney inreducingtheiremissions. ForfirmswithplentyofsurplusC02emissions(givenawayfreeofchargeinthefirstplace!)there hasbeenahugewindfallgain."Polluterpays"seemstohavebeenreplacedwith"polluterearns"! Themajorpowergeneratorshavebeengivenafreeblockofpollutionrightswhichtheycanthen sellontothemarketandmakeaprofit.DEFRA,theUKenvironmentagencyhasestimatedthatthe windfallprofitsfortheelectricitygeneratorsintheUKmighthavebeenashighas1.5bn. OnecriticismoftheEUcarbontradingschemeisthattheEUallocatedinitialallowancesfree ratherthanusingamarketbasedauctionsystem. Ascoalproductionexpands,soC02emissionsarerising,andthepowerstationshavetobuyextra emissionscredits,butthepriceofcreditsislowsotheconsequencesforthepowergeneratorsare notsignificant.EmissionsfromcoalfiredpowerstationsintheUKin2006aloneincreasedby8%! Consumersarepayingthepriceofhigherenergybillsbuttheyarenotgettingtheenvironmental payoffintermsofreducingcarbonproductionasacontributiontocontrollingclimatechange. AdaptedfromEconomicsintheNews,Tutor2u,June2007
161
MiniCaseStudy:Draxfeelstheheatofrisingcarbonprices ItisimpossibletomissthegiantDraxcoalfiredpowerstationthatstraddlestheA1near FerrybridgeinYorkshireanddominatesthelandscapeformilesaroundisthelargestinWestern Europeandsuppliesabout7percentoftheUKselectricity.Ofcoursegeneratingelectricityfrom coalnecessitatesplentyofcarbonemissionsfiguresshowthateverysixmonthsDraxcreates nearly10milliontonnesofCO2and,underthetermsoftheEUscarbontradingscheme,itmust notonlypayforcoalbutalsopurchaseemissionallowances.Ithasannouncedthatthecombined costofcoalandCO2permitshasnearlydoubledoverthelastyearfrom222mto413m. Draxwasgivenfewerfreeemissionsallowancesthisyearandithashadtogotothecarbon marketandpurchasepermitstoemit6.5mtonnesofCO2,comparedwithjust3.6mtonneslast year.Atthesametimethemarketpriceofcarbonhasrisenfrom3to16.50. Puttingapriceoncarbonisamarketbasedstrategydesignedtochangetheincentivesfor pollutingbusinesses.Ifcarbontradingworks,itoughttoprovideovertimeanincentivefor polluterstoinvestinmorepollutionefficientproductionprocessesandtechnology. ThereissomeevidencethatDraxisrisingtothechallengeinrecentmonthsthebusinesssays thatithasrefittedturbinestomakeitsgeneratorsmoreefficientandalsotakenstepstoincrease itscofiringcapacityaprocessthatallowsthepowerstationtoburningorganicmattersuchas pelletsmadefromstrawtocreatepowerinalliancewithcoal.Theircapitalinvestment programmeisscheduledtobeworthover40mthisyear. ForDraxthekeytooperatingaprofitablepowerstationistochargeahigherpricetoitscustomers thanthecostofgeneratingtheelectricity.Theirhalfyearfinancialstatementoffersawindowonthe challengesfacingthebusiness.InthesixmonthstotheendofJune2008thefigureswereas follows: Averageachievedpricechargedtoelectricitybuyers=53.6ppermegawatt(11%higher thanatthesametimelastyear) Averagefuelcost(excludingCO2allowances)=23.6/MWh(34%higherthanatthesame timelastyear) Averagefuelcost(includingCO2allowances)=31.8/MWh(72%higherthanatthesame timelastyear) Unitcostshaverisenmuchmorequicklythanthefinaloutputpriceleadingtoareductionin operatingprofits.Draxhasbeenhithardbythesurgingpriceofcoalonworldmarketsatonneof coalwassellingfor$218inJune2008drivenhigherbytheinabilityofcountriessuchasSouth AfricatoexpandproductionsufficientlyquicklytomeetstrongdemandfromChina,Indiaandmany otheremergingmarketcountries. Source:Tutor2uBlog,August2008 Kyoto EmissiontradingwasakeyfeatureoftheKyotoProtocolasastrategytoaddresssomeofthe threatsposedbyclimatechangein1997.Kyotoallowstradingofpermitsforcarbondioxide betweenindustrialisedcountriesbuttheUnitedStateswithdrewfromtheagreementin2001and sincetheUSArepresents32%ofemissionsamongstdevelopedcountrieswithemissiontargets, theabsenceoftheUSAfromanembryonictradingsystemwillseriouslyreducedemandfor permitsandthereforedrivedowntheirpriceandeffectiveness.
162
Pollutionregulation Insteadofrelyingoninterventioninthemarketmechanismbyusingtaxation,subsidiesorpollution permits,thegovernmentanditsappointedagenciescanregulatethelevelofoutputandpollution inamarket.Intheory,thegovernmentcouldsetaquotasothatoutputissetatthesocialoptimum. Morefrequently,minimumorenvironmental/emissionstandardsarewidespreadinmany industries.Thisrequiresregulatorybodiestomonitor(inspect)andfinefirmsthatdonotmeetthe standardssetforwaterandairquality.The1989EnvironmentalProtectionActforsetstandardson emissionsforfirmsthatcarriedoutchemicalprocesses,wasteincinerationandoilrefining. Compliancewithenvironmentalregulationscanbeverycostlytoenforceanditmaybeimpossible tomonitorallfirmsaccuratelybecauseofimperfectinformation.Regulationalsodoesnotbring inanydirecttaxrevenueflowsthatcanbeusedtofundenvironmentalimprovementschemesor compensatethosewhohavebeennegativelyaffectedbypollution. TheSternReviewonClimateChange TheSternReviewisanimportantpieceofworkdespiteithavingcomeunderattackfromvarious quarters.Itisareportthatcallsforactionsocalledmitigationpoliciestoreducecarbon emissionsnowtofirststabiliseandthenreducetheeffectsofclimatechange. SelectedquotesfromSirNickStern Globalwarmingisthegreatestmarketfailurethattheworldhaseverseen. Whatisgoingtohappentoourclimateinthenexttwentyorthirtyyearsisalreadydetermined. Thephysicalgeographyoftheworldtransformsthehumangeographyoftheworld. TheSternReviewconcludesthatthesocialcostofcarbontoday,iftheworldcontinuestotravel alongabusinessasusualpath,ismuchhigherthantheverylow(andpossiblyzero)marginal costsofundertakingthecheapestformsofmitigationnow.Itrationalisesthecaseforactionnow includingthecasefordeepcutsincarbonemissions.Societiesthatchoosetobehavemyopically oftenshortentheirexpectedlifetimes! Nolaissezfairesolution Theeconomicsofclimatechangehastheeconomicsofriskanduncertaintyatitscore.The unmitigatedaccumulationofgreenhousegasesintheatmosphereposesevergreaterrisks,and thepolicychallengeistofindthemostcosteffective,efficientandequitablewaytoreducethe risks.Itisworthreemphasisingthattheproblemisnotgoingtobesolvedwithoutinternational collectiveaction:thereisnolaissezfairesolution. Source:http://www.hmtreasury.gov.uk/media/B6F/58/paper_a.pdf AccordingtotheSternReview,Theworldisalreadyirrevocablycommittedtofurtherclimate changes,whichwillleadtoadverseimpactsinmanyareas.Globaltemperatures,andthereforethe severityofimpacts,willcontinuetoriseunlessthestockofgreenhousegasesisstabilised. Urgentactionisnowrequiredtopreventtemperaturesrisingtoevenhigherlevels,loweringthe risksofimpactsthatcouldotherwiseseriouslythreatenlivesandlivelihoodsworldwide. AQuestionofRisk Environmentalpolicyisbasicallyabouttheeconomicsofriskwearedealingwithverylong timehorizonsandtherearemanyuncertaintiesinvolvedwhenmodellingtheeffectsofclimate change Externalities
163
Globalwarmingisanexternalitypureandsimple.ItdoesnotmatterwhocreatestheCO2 greenhousegases,atonneofCo2isatonneofCo2.Buttheeffectsonthephysicalandhuman geographyoftheworldarenotequitable.IndeedSterntalksofadoubleinequity,75%of emissionscomefromtherichadvancednations,buttheconsequencesofglobalwarmingwillfall disproportionatelyonthepoorernations,manyofwhomlacktheresourcestoadapttosomeofthe effects. Measuringthesocialcostofcarbon(SCC)socialcost=privatecost+externalcosttheStern Reviewcalculatesthesocialcostofcarbontobe$85pertonneofCO2andthatthisfigurerises overtime.However,strongandeffectivemitigationpoliciescanreducetheSCCtoaround$25$35 pertonneofCO2 Pollutionabatementnotafreelunch Emissionsreductionisnotazerocostoptionweusetheconceptofmarginalabatementcost i.e.thecostofreducingemissionsbyonetonneactingnowtocutemissionseffectivelyimposesa costoncurrentgenerationsthatcostcanbeexpressedintermsoflostgrowththroughhigher prices. TheSternReviewestimatesthatthecostofreducingCO2emissionsalongapathconsistentwith stabilisingtheconcentrationofCO2willbeintheregionof1%ofGDPbythemiddleofthiscentury globalGDPislikelytobearound$100trillionby2050,sothiswouldmeanannualcostsinthe orderof$1trillionbythenthisfigureisroughlythesameamountasisspentworldwideon advertising,andhalfwhattheWorldBankestimatesafullblownflupandemicwouldcost Thepoweroftechnologyandinnovation Technologicalchangearisingfrominnovationand inventionhasthepowertoreducemarginal abatementcostspolicythereforeneedstopromote innovationatalllevels.Butthereisnoguaranteethat relyingonalaissezfairemarketapproachwillyield theinnovationsrequiredintime. Valuingtheenvironmenttodayandlongdistancesintothefuture o Theeffectsofclimatechangetodayandtheneartermraiseissuesofintragenerational equity o Howmucheconomicgrowthneedstobesacrificedtodaytoprotectfuturegenerations? o Howshouldwevaluetodaythewelfareoffuturegenerations? TheSternReviewchoosestogivefuturegenerationequalethicalweightbychoosingaverylow discountratetovaluetheimportanceoftheenvironmenttofuturegenerations. Mitigationpolicies Whatarethemainoptionsformitigationi.e.reducingemissions? 1. Putapriceoncarbon:Anexternalityrequiresapriceforemissionsthisisthefirsttask ofmitigationpolicyinternalisetheexternalitiesforexamplethroughtheuseofcarbon taxesand/orcarbontradingtocreatetherightincentivestochangebehaviour 2. Promoteresearch,developmentanddeploymentofnewtechnologies:Noteherethe importanceofsecurepropertyrightssinceinadequatepropertyrightscanprevent
164
investorsreapingthefullreturntonewideas.Businessesneedtheincentivetotaketherisk ofsinkingcostsintoresearchprojects. 3. Regulatewherenecessaryandseektoeducate:Effectiveregulationandtoughemission standardscanworkandthereisakeyroleforgovernmenttoseektodeepenpublic understandingofresponsiblebehaviour. Stern:themitigationofexternalitiesfromCO2emissionsisaglobalpublicgoodbutthereare somerisksofpeople/countriesfreeridingonthepositiveactionsofothers? SuggestionsforfurtherreadingoncarbontradingandtheSternReview AirlinesincludedinEUCO2plans(BBCnews,July2008) ArticlesonclimatechangefromtheIndependent Ataglance:TheSternReview(BBCnews,October2006) Australiancarbonemissionsplan(BBCnews,July2008) Californiapassesemissionslaw(BBCnews,September2006) Carbonmarket'svaluehits$64bn(BBCnews,May2008) CarbonPositive CarbonTradeWatch CleanDevelopmentMechanismisworking(BBCnews,May2008) Costoftacklingglobalclimatechangehasdoubled,warnsStern(Guardian,June2008) MPsbackpersonalcarboncredits(BBCnews,May2008) Oilsandsanenvironmentalcatastrophe(Guardian,July2008) TimHarfordoncarbonnegativity(FinancialTimes,July2008) UKsfirstemissionszonebegins(BBCnews,February2008) Whatiscarbontrading?Canitsavetheworldfromglobalwarming?(Independent,October2006)
165
31.
CostBenefitAnalysis
Inaworldoffinitepublicandprivateresources,weneedastandardforevaluatingtradeoffs, settingpriorities,andfinallymakingchoicesabouthowtoallocatescarceresourcesamong competinguses.Costbenefitanalysisprovidesawayofdoingthis. Thecostbenefitprinciplesaysthatyoushouldtakeanactionif,andonlyif,theextra benefitfromtakingitisgreaterthantheextracost Herearesomeexampleswheretheprinciplemightbebuiltintoyouranalysisandevaluation 1. Costsandbenefitsofsubsidiese.g.thebiofueldebateorsubsidies 2. Costsandbenefitsoftheintroductionofcompetitione.g.postalmarketliberalisation 3. Costsandbenefitsofdifferentstrategiesdesignedtoreduceincomeandwealthinequality e.g.thenationalminimumwageorariseinthetoprateofincometax 4. CostsandbenefitsoftheintroductionofcarbontradingasawayofreducingCO2 emissions 5. Costsandbenefitsofmajorinfrastructuralprojectssuchasnewmotorways,London2012 6. Costsandbenefitsofadecisiontorelaxplanningcontrolsonnewhousebuilding Whatiscostbenefitanalysis? Costbenefitanalysis(COBA)isatechniqueforassessingthemonetarysocialcostsand benefitsofacapitalinvestmentprojectoveragiventimeperiod.Theprinciplesofcostbenefit analysis(CBA)aresimple: 1. Appraisalofaproject:Itisaneconomictechniqueforprojectappraisal,widelyusedin businessaswellasgovernmentspendingprojects(forexampleshouldabusinessinvestin anewinformationsystem) 2. Incorporatesexternalitiesintotheequation:Itcan,ifrequired,includewider social/environmentalimpactsaswellasprivateeconomiccostsandbenefitssothat externalitiesareincorporatedintothedecisionprocess.Inthisway,COBAcanbeusedto estimatethesocialwelfareeffectsofaninvestment 3. Timematters!COBAcantakeaccountoftheeconomicsoftimeknownas discounting.Thisisimportantwhenlookingatenvironmentalimpactsofaprojectinthe yearsahead UsesofCOBA COBAhastraditionallybeenappliedtobigpublicsectorprojectssuchasnewmotorways,by passes,dams,tunnels,bridges,floodreliefschemesandnewpowerstations.Ourexamplelater considerssomeofthesocialcostsandbenefitsofthenewTerminal5forHeathrowairport. ThebasicprinciplesofCOBAcanbeappliedtomanyotherprojectsorprogrammes.Forexample, publichealthprogrammes(e.g.themassimmunizationofchildrenusingnewdrugs),an investmentinanewrailsafetysystems,oropeninganewrailwayline.Anotherexamplemight betouseCOBAinassessingthecostsandbenefitsofintroducingcongestionchargesfor motoristsinLondon.Costbenefitanalysiswasalsousedduringtherecentinquiryintogenetically modifiedfoods.Increasinglytheprinciplesofcostbenefitanalysisarebeingusedtoevaluatethe returnsfrominvestmentinenvironmentalprojectssuchaswindfarmsandthedevelopmentof othersourcesofrenewableenergy,anareawheretheUKcontinuestolagbehind. Becausefinancialresourcesarescarce,COBAallowsdifferentprojectstoberankedaccordingto thosethatprovidethehighestexpectednetgainsinsocialwelfarethisisparticularlyimportant giventhelimitationsofgovernmentspending.
166
MainStagesintheCostBenefitAnalysisApproach Attheheartofanyinvestmentappraisaldecisionisthisbasicquestiondoesaplannedproject leadtoanetincreaseinsocialwelfare? o Stage1(a)Calculationofsocialcosts&socialbenefits.Thiswouldincludecalculation of: o TangibleBenefitsandCosts(i.e.directcostsandbenefits) o IntangibleBenefitsandCosts(i.e.indirectcostsandbenefitsexternalities) o Thisprocessisveryimportantitinvolvestryingtoidentifyallofthesignificantcosts& benefits o Stage1(b)Sensitivityanalysisofeventsoccurringthisrelatestoanimportant questionIfyouestimatethatapossiblebenefit(orcost)isxmillion,howlikelyisthat outcome?Ifyouarereasonablysurethatabenefitorcostwilloccurwhatisthescaleof uncertaintyabouttheactualvaluesofthecostsandbenefits? o Stage2:Discountingthefuturevalueofbenefitscostsandbenefitsaccrueovertime. Individualsnormallyprefertoenjoythebenefitsnowratherthanlatersothevalueof futurebenefitshastobediscounted o Stage3:Comparingthecostsandbenefitstodeterminethenetsocialrateofreturn o Stage4:Comparingnetrateofreturnfromdifferentprojectsthegovernmentmay havelimitedfundsatitsdisposalandthereforefacesachoiceaboutwhichprojectsshould begiventhegoahead Evaluation:CriticismsofCOBA ThereareseveralobjectionstotheuseofCBAforenvironmentalimpactassessment: 1. Problemsinattachingvaluationstocostsandbenefits:Somecostsareeasytovalue suchastherunningcosts(e.g.staffcosts)+capitalcosts(newequipment).Othercostsare moredifficultnotleastwhenaprojecthasasignificantimpactontheenvironment.The valueattachedtothedestructionofahabitatistosomepricelessandtoothers worthless.CostsarealsosubjecttochangeovertimeI.e.theconstructioncostsofa newbridgeoverariverortheintroductionofelectronicroadpricing 2. TheCBAmaynotcovereveryoneaffected(i.e.allthirdparties)inevitablywithmajor constructionprojectssuchasanewairportoranewroad,thereareahugenumberof potentialstakeholderswhostandtobeaffected(positivelyornegatively)bythedecision. COBAcannothopetoincludeallstakeholdersthereisariskthatsomegroupsmightbe leftoutofthedecisionprocess a. Futuregenerationsaretheyincludedintheanalysis? b. Whatofnonhumanstakeholders? 3. Distributionalconsequences:Costsandbenefitsmeandifferentthingstodifferent incomegroupsbenefitstothepoorareusuallyworthmore(orarethey?).Thosereceiving benefitsandthoseburdenedwiththecostsofaprojectmaynotbethesame.Arethe loserstobecompensated?Tomanyeconomists,theequityissueisasimportantasthe efficiencyargument. 4. SocialwelfareisnotthesameasindividualwelfareWhatwewantindividuallymaynot bewhatwewantcollectively.Doweattachadifferentvaluetothosewhofeel
167
passionatelyaboutsomething(forexamplethebuildingofnewhousingongreenfield sites)contrastedwiththosewhoaremoreambivalent? 5. Valuingtheenvironment:Howarewetoplaceavalueonpublicgoodssuchasthe environmentwherethereisnomarketestablishedforthevaluationofpropertyrightsover environmentalresources?Howdoesonevaluenuisanceandaestheticvalues? 6. Valuinghumanlife:Somemeasurementsofbenefitsrequirethevaluationofhumanlife manypeopleareintrinsicallyopposedtoanyattempttodothis.Thisobjectioncanbepartly overcomeifwefocusinsteadontheprobabilityofaprojectreducingtheriskofdeath andthereareinsurancemarketsinexistencewhichtellussomethingabouthowmuch peoplevaluetheirhealthandlifewhentheytakeoutinsurancepolicies. 7. Attitudestoriske.g.acostbenefitanalysisoftheeffectsofgeneticallymodifiedfoods a. PrecautionaryPrinciple:Assumetoxicityuntilprovensafe i. Ifindoubt,thenregulate b. FreeMarketPrinciple:Assumeitissafeuntilahazardisidentified i. Ifindoubt,donotregulate. 8. Weighingqualitativefactorssuchassocialinclusioneffects,policyintegration/cohesion, accessibility/discriminationandthelegacyeffectsofcapitalinvestment Despitetheseproblems,mosteconomistsarguethatCBAisbetterthanotherwaysofincluding theenvironmentinprojectappraisal. Discountingthefuture Wouldyouratherhave1000ofincometodayor1000ofincomeinthefuture(sayin3years?). Theanswerisprobablynow,because1000inthreeyearstimeisunlikelytobuyasmanygoods andservicesasitdoesnow(becauseofinflation).Andalsobecause1000putintoasavings accounttodaywillyieldinterest. Discountingisawidelyusedtechniqueaspartofcostbenefitanalysis.Thetechniqueof discountingreflectsthefollowing: Thevalueofacostorbenefitnow>thevalueofacostorbenefitinfutureyears Discountingreflectsthisbyreducingallfuturecostsandbenefitstoexpressthemastodays values.Thekeyquestionis:Howdoyouchooseaninterestrateforreducingfuturecoststogive themapresentvaluetoday? Settingageneraldiscountratefornewprojectshasimportantimplicationsfortheenvironment: 1. Alowdiscountrateisoftenfavouredbyeconomistssincetheyarguethatinvestingahigh proportionofcurrentincomeisagoodwayofprovidingforthefuture 2. Ahighdiscountratemayalsobefavouredsinceitdiscouragesinvestment(andby implicationenvironmentaldamage)inthepresent Mostprojectshavelifetimesof2030yearswithmanyofthebigcostsarisingearlyinaproject e.g.fromconstructionwhereasthestreamofbenefitsfromaprojectoccuroveramuchlonger periodoftime.Butformanyhugeconstructionprojects,someofthecostsonlybecomeapparent inthelongrun.Considerthebuildingofanewnuclearpowerstation.Environmentalistswould arguethatthereisalonglistofcostsfromwastemanagementanddecommissioningwhichstretch over100yearsintothefuturewhereasnosocialbenefitsexisttooffsetthesecostsbeyondyear30 or40(wherethenuclearpowerstationmightreasonablybeexpectedtobereadyforclosure).
168
Thevalueofdecommissioningcostsover100yearsawayisalmostnegligiblenomatterwhat discountrateweuse.Thismakesdiscountingdifficulttojustify RevealedPreferenceValuingtheBenefitsfromaProject Accordingtosomeeconomists,thevaluationofbenefitsandcostsusedinCOBAshouldreflectthe preferencesrevealedbychoiceswhichhaveactuallybeenmadebyindividualsandbusinesses indifferentmarkets. Informationcontainedinthedemandcurvetellsusmuchabouthowmuchpeoplearewillingand abletopayforsomething.Thisisimportantinrevealedpreferencetheory.Whenconsumersmake purchasesatmarketpricestheyrevealthatthethingstheybuyareatleastasbeneficialtothemas themoneytheyrelinquish. CostbenefitanalysisinpracticeHeathrowTerminal5 ThedebateoverwhetherthereshouldbeafifthterminalatHeathrowairporthasfierceandlong lasting!Theofficialplanningenquiryreportedafter5yearsandhavingcostmanymillionsof pounds.Therivalargumentsattheinquiryhighlightedmanyexamplesofenvironmentalimpact (externalities)noise,airquality,riversetc.butconcludedthatthesewerenotenoughtorefuse planningpermissionandthatthenewterminalprojectshouldgoahead. Thecaseforterminal5 1. Economicgrowth:DemandforairtravelinsoutheastEnglandisforecasttodoubleinthe next20years,makingexpansionvitalmanythousandsofjobsandbusinessesdepend onHeathrowairportexpandingtoprovidesufficientsupplycapacitytomeetthisgrowing demand.AnincreaseinthecapacityofHeathrowwillmakebestuseofairport'sexisting infrastructureandland(nearly3,000acres). 2. Theeconomyandtrade:TheUKwillloseairlinesandforeigninvestmenttoEuropean rivalsifitdoesnotmeetdemand.Thebenefitsofaworldbeatingindustrywouldbe diminishedmanysectorsofouraviationindustryhaveacomparativeadvantageandadd hugesumstoourbalanceofpayments 3. Jobs:Theterminal5projectwillcreateorsafeguardanestimated16,500jobs,aswellas creating6,000constructionjobsduringthebuildingphasethiswillhavemultipliereffects onthelocal/regionalandnationaleconomy 4. Transport:Theterminalwillbethecentreofaworldclasstransportinterchange,withnew Tubeandraillinks.Cartrafficwouldriseonlyslightlythesocialcostsofincreasedtraffic congestionhavebeenexaggeratedbytheenvironmentalists 5. Environment:Thesiteearmarkedforterminal5iscurrentlyadisusedsludgeworks,and anydisplacedwildlifeandplantlifewillbecarefullyrelocated.Thenoiseclimatearound HeathrowAirporthasbeenimprovingformanyyears,eventhoughthenumberofaircraft movementshasincreasedconsiderablypartlyduetothephasingoutofolder,nosier aircraft 6. Noiseandnightflights:BAApromisesnoincreaseinoverallnoiselevelsorinnightflying. Thenumberofflightswouldriseonly8% TheobjectionstoTerminal5 1. Growth:BAAforecastsaremisleadingandwillleadtouncontrolledexpansion,ratherthan targetingbettersolutionssuchasusingexistingspaceatotherairports.
169
2. Theeconomy:HeathrowalreadyhasthebiggestcapacityinEurope,andambitionsto extenditsleadaremerely"commercialprestige"ratherthanhavinglongterm macroeconomicbenefits 3. Jobs:Only6,000jobswillbecreatedatinyfractionofallthenewjobsintheSouthEast. Localstudiessayjobswillincreaseanywayevenwithoutafifthterminal 4. Transport:Therewillbeasignificantincreaseinroadwideningandcarparkstocaterfor thetensofthousandsofextracarjourneystotheairporteveryyear 5. Environment:Airpollutionwillincreasesignificantly,andhundredsofacresofwildlifeand GreenBeltlandwillbelostforever.Plustheenvironmentalcostsofincreasedtraffic congestion 6. Noiseandnightflights:Moreflightswillmeanmorenoiseundertheflightpaths,andthe pressureforcontroversialnightflightsandathirdrunwaywillincreasetheregulatorswill becapturedbytheairlinesandairportauthoritiesandwilleventuallybepressurizedinto givingwayonallowingmorenighttimeflights ThesearejustafewoftheargumentsraisedforandagainsttheTerminal5project.Formore newsontheprojectconsultwww.baa.com/main/airports/heathrow/terminal_5_frame.html Anationalsmokingban AccordingtoacostbenefitanalysisperformedfortheChiefMedicalofficer'sAnnualReviewof PublicHealthpublishedinJuly2004,abanonsmokinginpublicplaceswouldbenefittheeconomy bybetween2.3bnand2.7bnayear.TheCOBAarguedthatabanonsmokinginpubs, restaurantsandcafeswouldnotreduceprofitsintheleisure,cateringandhospitalityindustry. Howevercriticsofthenewstudyrespondedbysayingthattheassumptionsbehindtheeconomic model,remainedunpublished.Themainfindingsofthecostbenefitanalysisaresummarisedinthe tablebelow. ANNUALBENEFITS Healthbenefits(reducedabsenteeism) Healthbenefits(reducedcostsofhealthcare) Healthbenefits(averteddeathsfromsecondhandsmokeamongst employees) Healthbenefits(reduceduptake,particularlynewyoungemployees) Healthbenefits(smokingcessation) Safetybenefits(damage,deaths,injuries) Safetybenefits(costtofireservices) Safetybenefits(administrationcosts) CostsavingstoNHSfromsmokingcessation Cleaningcostsanddamagetoequipmentavoided Productiongains Total AnnualCosts Productionlosses(smokingbreaks) Lossestocontinuingsmokers(lossofsatisfaction) Lossestoquitters(lossofsatisfaction) LossestotheTreasury Total
MILLION 70140 4 21 550 1600 57 0.2 6.3 Notestimated 100 340680 27003100 million 430 155 550 1145
170
Someofthestakeholdersaffectedbythesmokingbanincludethefollowing Losersfromthedecision Drycleaners(smokefreepubsmeanless needforpeopletolaundersuitsandother clothes) Specialisedtobacconists Bingohalls PubspubclosuresintheUKhaverunat anetrateof27perweekduring2008 Winnersfromthedecision Packagingcompaniesthedemandforbeercans hasincreasedasmorepeopledrinkathome Pizzadeliverycompaniesmorepeopleordering takeawayinsteadofpubmeals Manufacturersofoutdoorpatioheaters,awnings anddecking Cigarettecompaniesdomesticdemandfor cigaretteshasfallenbuttheyhaveoffsetthisby growingsalestoEasternEuropehelpedbythe fallingexchangerate
AnumberofmajorinfrastructuralprojectsareplannedintheUKoverthecomingyears.Eachof themcouldbeconsideredusingsomeoftheprinciplesofcostbenefitanalysis.Examplesinclude: 1. Nuclearpowerplants:Expansionorrenovationplannedatmorethanadozennuclear facilities,raisingconcernsaboutsafetyandwastedisposal. 2. Reservoirs:Tocombatlongtermwatersupplyshortagesthegovernmentisplanningto expandsixreservoirsintheSouthandSoutheast 3. Incinerators:NewEUenvironmentalregulationscouldleadtothebuildingofthree massive,centraliseddisposalunitsformillionsoftonnesofcommercialandhousehold waste. 4. Airportsandextrarunways:Withanextra100mpassengerspredictedtobeusingUK airportsby2030,therearenewrunwaysplannedforfourairportsaspartofahuge expansionprogramme. 5. TheSevernBarrage:Harnessingtidalpowercouldgenerateupto5percentofBritain's electricityneedsfromtheSevernBarragealone. 6. Gaspipelines:Sixhugeundergroundgasfieldsbuiltaftersurgeinimportsofliquefied petroleumgasandcollapseinNorthSeasupply. 7. Newroads:About500milesofextraroadsareplannedtogetherwithaseriesofroad wideningschemes Torecap,costbenefitanalysisisbasicallyanappraisaltechniquethattriestoplacemonetary valuesonallbenefitsarisingfromaprojectandthencomparesthetotalvaluewiththeproject's totalcost.Ithasnumerouspotentialapplicationsalthoughthereareinherentdifficultieswiththe issueofvaluation.EssentiallytheprocessofCOBAisacomparativeone,sothatwecanperhaps makejudgementsaboutwhichprojectsfromalimitedchoiceshouldbegiventhegoahead. Suggestionsforfurtherreadingoncostbenefitanalysis Severnbarragewillbecostlyecologicaldisaster,sayenvironmentgroups(Guardian,June2008)

EconA2Micro200 Full

Caricato da

Informazioni sul documento

Descrizione originale:

Copyright

Formati disponibili

Condividi questo documento

Condividi o incorpora il documento

Opzioni di condivisione

Hai trovato utile questo documento?

Questo contenuto è inappropriato?

Copyright:

Formati disponibili

EconA2Micro200 Full

Caricato da

Copyright:

Formati disponibili

A2Economics

Total Output (Q)

Diminishingreturnsareapparent heretotaloutputisrisingbutata decreasingrate

Unitsof Capital 20 40 60 80 100

Unitsof Labour 150 300 450 600 750

Total Output 3000 7500 12000 16000 18000

%Changein Inputs 100 50 33 25

%Changein Output 150 60 33 13

ReturnstoScale Increasing Increasing Constant Decreasing

Output TotalFixed (Q) Costs(TFC)

MarginalCost (thechangeintotal costfromaoneunit changeinoutput)

Ifmarginalcostisbelowaveragecostthenaveragemustbefalling.EvenifMCisrising,ACfalls ifMC<AC.Forthisreason,MCcurveintersectstheACcurveatthelowestpointoftheAC curve.Diminishingreturnsstartstooccurwhenmarginalcoststartstorise. Costs MarginalCost (MC) AverageTotal Cost(ATC)

Average VariableCost (AVC)

AverageFixed Cost(AFC) Q1 Q2 Output(Q)

AC2 AverageTotal Cost(ATC1)

Average VariableCost (AVC1)

Suggestionsforbackgroundreadingonchangesinbusinesscosts Cadburysplanstoincreaseprices(BBCnews,February2008) Drycleanersfacingrisingcosts(BBCnews,June2008) Grainpricesaresqueezingbakers(BBCnews,April2008)

Costs:Assumethecostofeachunitofcapital=600,Land=80andLabour=200 Becausethe%changeinoutputexceedsthe%changeinfactorinputsused,then,althoughtotal costsrise,theaveragecostperunitfallsasthebusinessexpandsfromscaleAtoBtoC.

EconomiesofScale A B LRAC1 Learning economies C

Externaleconomiesofscale(EEoS) Externaleconomiesofscaleoccuroutsideofafirmbutwithinanindustry.Forexample investmentinabettertransportationnetworkservicinganindustrywillresultinginadecreasein

Totalrevenueis maximisedwhen MR=0

Ped>1foraprice fallalongthis lengthofAR

Priceelasticityof demand=1atthis output

Revenue AndCost MarginalCost

Profitsare increasingwhen MR>MC

Profitsare decreasingwhen MR<MC

AC1 AC2 AR (Demand)

Theshortrunsupplydecisiontheshutdownpoint Thetheoryofthefirmassumesthatabusinessneedstomakeatleastnormalprofitinthelongrunto justifyremaininginanindustrybutthisisnotastrictrequirementwhenthefirmwillcontinueto produceaslongastotalrevenuecoverstotalvariablecostsorputanotherway,solongaspriceper

AC1 AC2 AR2

MR2 Q1 Q2 MR1 Output(Q)

18.0 16.0 14.0

14.0 12.0 10.0 8.0 6.0 4.0 2.0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

12.0 10.0 8.0 6.0 4.0 2.0

CafDirect FairTrade Traidcraft DivineChocolate TheEdenProject

o FifteenFoundation(JamieOliver) o HousingAssociations o Microcreditdevelopedbythe GrameenBankanditsfounder,the NobelPrizewinnerMuhammadYu

Principals: Shareholders OWNERSHIP

AC2 P2 AR2(Demand)= MR2

MD2 Q1 IndustryOutput(Q) Q2 Output(Q)

Marketequilibriumoutputwhere demand=supplyandwhereprice =marginalcostofproduction

NetLossofEconomic WelfarefrompriceP2 raisedabovemarginalcost

Suggestionsforfurtherreadingonaspectsofcompetitivemarkets Consumersindangerofbeingmisledbypricecomparisonsites(Independent,October2007) Tescoaddstocontestabilityindigitaldownloads(Tutor2ublog,April2008)

Monopolydemand (AR)=market demand MR Q1 Output(Q)

TheprofitmaximisinglevelofoutputisatQ1atapriceP1.Thiswillgeneratetotalrevenueequal toOP1aQ1,butthetotalcostwillbeOAC1aQ.Astotalrevenueexceedstotalcoststhefirmmakes abnormal(supernormal)profitsequaltoP1baAC1. Theeffectofariseincostsonmonopolypriceandprofits

AC2 Revenue Costand Profit MonopolyProfit atPriceP1 MonopolyProfit atPriceP2

Monopoly Demand(AR) MR Q2 Q1 Output(Q)

Revenue Costand Profit

Monopoly Demand(AR) MR Q1 Qc Output(Q)

Price, Cost Supply(Marginal Cost)

PeakDemand OffPeak Demand MRPeak

MarketA Price MarketB

ProfitfromsellingtomarketA witharelativelyelasticdemand andchargingalowerprice

DemandinsegmentBofthe marketisrelativelyinelastic.A higherunitpriceischarged

MRa MRb Qa Quantity Qb ARb

PricediscriminationonPriceline(ThePricingBlog,May2008) Productsabotagehelpsconsumers(BBConline,TimHarford,August2007) Revisiononbusinesspricingstrategies(Tutor2uBlog,April2008) TimHarfordandtheSecretCappuccino(YouTube) YouTellUsWhatYourSeatIsWorth(NewYorkTimes,July2008)

Netlossof consumersurplus Netlossof producersurplus

Market Demand Monopoly Demand MR Q1 Q2 Q1 Output(Q)

Asimilarresultisseeninthenextdiagramwhichmakestheassumptionofconstantlongrun averageandmarginalcostsunderbothcompetitionandmonopoly.Thedeadweightlossof welfareundermonopoly(whoseprofitmaximisingpriceisP1andQ1)isshownbythetriangle ABC.ThecompetitivepriceandoutputisPcandQcrespectively.

Revenue Costand Profit P1 A

MonopolyProfit atPriceP1 B Pc C LRAC=LRMC

Monopoly Demand(AR) MR Q1 Qc Output(Q)

CompetitiveMarket Price(P) Price(P) Market Supply Competitive Supply (MC) PureMonopoly

Monopoly Supplywith Scale Economies

AssumewestartoutatP1andQ1: Willafirmbenefitfromraisingprice aboveP1? Willitbenefitfromcuttingpricebelow P1?