Welcome to the

A2 Micro Workshop
November 2012
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Examiners like answers that make
connections
These are good connective phrases
by contrast
A consequence of
this might be
therefore
this might
mean
on the other
hand
this is because
Examiners reward
answers that provide
chains of
reasoning
1. Knowledge of economic concepts and
facts.
2. Application of knowledge and
understanding
3. Analysis: explain economic theory
4. Evaluation: prioritise evidence and
arguments; make reasoned
judgements and recommendations;
reach and present supported
conclusions
Efficiency & Welfare in
Contestable Markets
Session 1

P3
Page number in your
workshop brochure
Build lots of real world
examples into your notes
Common industries used
include food retailers,
energy, banks, airlines,
technology sectors
Contestable markets
Where an entrant has access
to all production techniques
available to existing
businesses and entry
decisions can be reversed
without cost
Key Contestability Factors
Absence of sunk costs Access to technology
Low consumer loyalty
Size of legal entry
barriers
Contestable Markets?
Streamed
Movies on
Demand
Retail
Coffee
Stores
Home-
Delivered
Pizza
Budget
"Value"
Hotels
City Bus and
Coach
Transport
Household
Mail Services
For each of
the industries,
choose
whether they
have Low
Contestability
(LC) or High
Contestability
(HC)
P3
Movies on Demand
Contestable Markets?
Streamed
Movies on
Demand
Retail
Coffee
Stores
Home-
Delivered
Pizza
Budget
"Value"
Hotels
City Bus and
Coach
Transport
Household
Mail Services
For each of
the industries,
choose
whether they
have Low
Contestability
(LC) or High
Contestability
(HC)
P3
LC
But
Rising!
Contestable Markets?
Streamed
Movies on
Demand
Retail
Coffee
Stores
Home-
Delivered
Pizza
Budget
"Value"
Hotels
City Bus and
Coach
Transport
Household
Mail Services
For each of
the industries,
choose
whether they
have Low
Contestability
(LC) or High
Contestability
(HC)
HC
P3
LC
But
Rising!
Contestable Markets?
Streamed
Movies on
Demand
Retail
Coffee
Stores
Home-
Delivered
Pizza
Budget
"Value"
Hotels
City Bus and
Coach
Transport
Household
Mail Services
For each of
the industries,
choose
whether they
have Low
Contestability
(LC) or High
Contestability
(HC)
LC
HC
HC
P3
Contestable Markets?
Streamed
Movies on
Demand
Retail
Coffee
Stores
Home-
Delivered
Pizza
Budget
"Value"
Hotels
City Bus and
Coach
Transport
Household
Mail Services
For each of
the industries,
choose
whether they
have Low
Contestability
(LC) or High
Contestability
(HC)
LC
HC
HC
HC
P3
Contestable Markets?
Streamed
Movies on
Demand
Retail
Coffee
Stores
Home-
Delivered
Pizza
Budget
"Value"
Hotels
City Bus and
Coach
Transport
Household
Mail Services
For each of
the industries,
choose
whether they
have Low
Contestability
(LC) or High
Contestability
(HC)
LC
HC
HC
HC
LC
P3
Contestable Markets?
Streamed
Movies on
Demand
Retail
Coffee
Stores
Home-
Delivered
Pizza
Budget
"Value"
Hotels
City Bus and
Coach
Transport
Household
Mail Services
For each of
the industries,
choose
whether they
have Low
Contestability
(LC) or High
Contestability
(HC)
LC
HC
HC
HC
LC
LC
P3
Great diagrams lift your
script!
Poor ones test
examiner patience
Diagrams must be big
Cost & Price
Output (Q)
Pricing in a Contestable Market Some Alternatives
Cost & Price
Output (Q)
Highly Contestable Market
Profit Maximising Output
Highly Contestable Market
Pricing to Maximise Revenue
AC
AR
MR
MC
AC
AR
MR
MC
P4
Cost & Price
Output (Q)
Pricing in a Contestable Market Some Alternatives
Highly Contestable Market
Profit Maximising Output
AC
AR
MR
MC
In the left hand
diagram draw in
the profit
maximising output
and price (label it
Q1 and P1.)
Q1
P1
C1
Price > Average Cost

Supernormal profits

High profits send
signals to other
suppliers
P4
Cost & Price
Output (Q)
Pricing in a Contestable Market Possible Long Run Equilibrium?
Highly Contestable Market
Profit Maximising Output
AC
AR
MR
MC
In the long run if
the market is highly
contestable which
level of price and
output is probable?
(Label this Q2 and
P2).
Q1
P1
C1
When AC = AR,
normal profits made,
a return sufficient to
keep factor inputs in
their present use
P2
Q2
P4
Pricing in a Contestable Market Some Alternatives
Cost & Price
Output (Q)
Highly Contestable Market
Pricing to Maximise Revenue
AC
AR
MR
MC
In the right hand
diagram show the
price and output
for a firm that
seeks to maximise
total revenue
P4
Pricing in a Contestable Market Some Alternatives
Cost & Price
Output (Q)
Highly Contestable Market
Pricing to Maximise Revenue
AC
AR
MR
MC
In the right hand
diagram show the
price and output
for a firm that
seeks to maximise
total revenue
P1
Revenue maximised
when marginal
revenue = zero
P4
Pricing in a Contestable Market Some Alternatives
Cost & Price
Output (Q)
Highly Contestable Market
Pricing to Maximise Revenue
AC
AR
MR
MC
In the right hand
diagram show the
price and output
for a firm that
seeks to maximise
total revenue
P1
C1
Revenue maximised
when marginal
revenue = zero
Still some super
normal profits made
Lower price and
higher output than
MC=MR
Revenue max means
a lower profit margin
is made usually
good for consumer
welfare but profit
has value too!
P4
Hit and Run Entry
Entry to a market in
expectation of making an
immediate profit
Can only occur if the
entrant does not incur
sunk costs
Economies of scope help
here i.e. Extending a
brand name into a new
market
P4
Hit and Run Entry
P4
Strong brands can make it easier to enter a new market!
Barriers to Entry and Exit
P5
Barriers to entry and exit
Block potential entrants
from making a profit
Protect the monopoly
power of existing firms
Maintain supernormal
profits in the long run
Barriers to entry make a
market less contestable
P5
Barriers to Entry?
V
P5
Barriers to Entry
Economies of scale Vertical integration Brand loyalty
Control of important
technologies
Expertise and
reputation
P5
Strategies to Limit Competition
Limit pricing tactics Predatory pricing tactics
Brand proliferation
Strategies to Limit Competition
Limit pricing tactics Predatory pricing tactics
Brand proliferation
When a firm sets price
low enough to
discourage new
entrants into the
market
Strategies to Limit Competition
Limit pricing tactics Predatory pricing tactics
Brand proliferation
When a firm sets price
low enough to
discourage new
entrants into the
market
Setting an artificially
low price for a product
in order to drive out
competitors
Strategies to Limit Competition
Limit pricing tactics Predatory pricing tactics
Brand proliferation
When a firm sets price
low enough to
discourage new
entrants into the
market
Setting an artificially
low price for a product
in order to drive out
competitors
Saturating the market
with a huge range of
similar products
Legal Entry Barriers
Market licences Patent protection
State awarded franchises Import controls
Examples of Exit Barriers
P5
Asset write-offs Lost consumer goodwill
Redundancy costs
Costs
Double Diagrams
Two diagrams can lift
your analysis e.g.
showing different cost
curves in the long run
Cost & Price
Output (Q)
Costs and contestability in different industries
Cost & Price
Output (Q)
Low MES, limited scale
economies, contestable market
High MES, falling LRAC, barriers to
contestability
LRAC
LRAC
P6
Cost & Price
Output (Q)
Costs and contestability in different industries
Low MES, limited scale
economies, contestable market
LRAC
Q1
Minimum
efficient
scale (MES)
Scope for many firms to
reach the MES
P6
Q3 Q2 Q1
Cost & Price
Output (Q)
Costs and contestability in different industries
Low MES, limited scale
economies, contestable market
LRAC
Q1
Output (Q)
High MES, falling LRAC, barriers to
contestability
Extensive internal
economies of scale
leading to lower LRAC
LRAC
Natural Monopoly
Minimum
efficient
scale (MES)
Scope for many firms to
reach the MES
Q4
P6
Cost & Price
Output (Q)
Cost Advantages for Existing / Established Businesses
Cost advantage for Firm A over
a potential rival Firm B
At output Q1 firm A has a big
cost advantage over a
potential rival firm B

Reasons?


Firm B
Firm A
Q1
AC (B)
AC (A)
P6
Cost & Price
Output (Q)
Cost Advantages for Existing / Established Businesses
Cost advantage for Firm A over
a potential rival Firm B
At output Q1 firm A has a big
cost advantage over a
potential rival firm B

1. Learning economies
2. Vertical integration
3. Lower customer churn
4. Monopsony power


Firm B
Firm A
Q1
AC (B)
AC (A)
P6
Cost ,
Price
Quantity of output
Plant close-downs and market exit
MC
AC
AVC
P7
Cost ,
Price
Quantity of output
Plant close-downs and market exit
MC
AC
AVC
P7
AR
MR
Q1
P1
Cost ,
Price
Quantity of output
Plant close-downs and market exit
MC
AC
AVC
P7
AR
MR
Q1
P1
C1
Cost ,
Price
Quantity of output
Plant close-downs and market exit
MC
AC
AVC
P7
AR
MR
Q1
P1
C1
Business is making a loss
here because P < AC
i.e. sub-normal profit
Cost ,
Price
Quantity of output
Showing the shut down price and the normal profit price on a diagram
assume this firm is operating in a perfectly competitive market
MC
AC
AVC
P8
Cost ,
Price
Quantity of output
Showing the shut down price and the normal profit price on a diagram
assume this firm is operating in a perfectly competitive market
MC
AC
AVC
P1
P1: Price = average cost,
normal profits made
P8
Cost ,
Price
Quantity of output
Showing the shut down price and the normal profit price on a diagram
assume this firm is operating in a perfectly competitive market
MC
AC
AVC
P2
P1
P1: Price = average cost,
normal profits made
P2: Price = average
variable cost
P=Min AVC is the shut down
price for a competitive firm
in short run
P8
Business Objectives
Most businesses are
profit-seeking but
not necessarily profit
maximising
Moving Away from Profit
Maximisation
1. The condition for profit maximisation is
that the firm produces where Marginal Cost
(MC) equals Marginal Revenue (MR)
2. Producing less than this means the firm is
missing out on revenue which is could gain.
3. Producing more than this means the extra
production costs the firm more than it is
receiving in revenue.
Satisficing
behaviour
Social
Enterprises
Recession
Nationalised
Industries
Response to
New Rivals
Government
Intervention
P9
Network Rail State-Owned Business
Aim - deliver a safe, reliable
and efficient railway
Profits are invested in
the railway network
Train operating companies pay Network
Rail for use of the rail infrastructure
In 2011 Network Rail made
profits of 750 million
Download all of todays
resources, including
suggested answers from
www.tutor2u.net/a2micro2012.pdf
http://www.scoop.it/t/unit-3-micro-business-economics
Session 2
Market Power, Pricing
Strategies, Economic
Efficiency and Welfare
P10
Market Shares in Retail Banking
Personal current accounts March 2010 market
share (%)

Lloyds TSB / Halifax Bank of Scotland 30
Royal Bank of Scotland Group (RBS) 16
HSBC (including First Direct) 14
Barclays 13
Santander (Abbey, Alliance & Leicester) 12
Nationwide Building Society 7
Co-operative Bank 3
National Australia Group Europe (Clydesdale Bank
& Yorkshire Bank)
2
Source: Office of Fair Trading
P10
The Reality of Market Power
Pricing
Power
Entry
Barriers
Monopsony
Supply
Chain
Control
Economies
of Scale
Industry Leadership Benchmark Businesses
Profits to re-invest Habitual consumption
P11
Economic Efficiency
P10
The main types of economic efficiency
Allocative Productive Dynamic
Where price = MC
Producing at the lowest
point of the
average cost curve
Changes in the
choices available in a
market over time
Cost & Price
Output (Q)
Allocative Efficiency Competition / Pure Monopoly
Perfectly Competitive Market
S1
D1
P1
P2
Entry of
new firms
drives
price
lower
MC
P12
S2
AC
Cost & Price
Output (Q)
Allocative Efficiency Competition / Pure Monopoly
Perfectly Competitive Market
S1
D1
P1
P2
Entry of
new firms
drives
price
lower
MC
P1 P1
AC
Q1
P12
S2
Cost & Price
Output (Q)
Allocative Efficiency Competition / Pure Monopoly
Cost & Price
Output (Q)
Perfectly Competitive Market Pure Monopoly Market
S1
D1
P1
P2
Entry of
new firms
drives
price
lower
AC
MC
AC
MC
Monopoly
demand
(AR)
MR
P1 P1
Q1 Q2
P2
P12
S2
Cost & Price
Output (Q)
Allocative Efficiency Competition / Pure Monopoly
Cost & Price
Output (Q)
Perfectly Competitive Market Pure Monopoly Market
S1
D1
P1
P2
Entry of
new firms
drives
price
lower
AC
MC
AC
MC
Monopoly
demand
(AR)
MR
P1 P1
Q1 Q2
P2
C2
P12
S2
Cost & Price
Output (Q)
Allocative Efficiency Competition / Pure Monopoly
Cost & Price
Output (Q)
Perfectly Competitive Market Pure Monopoly Market
S1
D1
P1
P2
Entry of
new firms
drives
price
lower
AC
MC
AC
MC
Monopoly
demand
(AR)
MR
P1 P1
Q1 Q2
P2
C2
Monopoly Profit
P>MC
Loss of allocative
efficiency
P12
S2
Monopoly pricing can lead
to deadweight loss of
consumer welfare
Price Discrimination
P12
Aims of Price Discrimination
P13
Extra Revenue Higher Profit Improved Cash Flow
Use Up Spare
Capacity
Types of Price Discrimination
1. Third-degree price discrimination occurs when
different prices are charged to groups of buyers in
totally separate markets.
2. First-degree price discrimination occurs when each
unit of output is sold at a different price such that all
consumer surpluses go to the seller.
3. Second-degree price discrimination occurs when the
seller prices the first block of output at a higher price
than subsequent blocks of output.
4. The hurdle method of price discrimination exists
when the seller offers a lower price, coupled with an
inconvenience that rich consumers prefer to avoid.
Cost & Price
Output (Q)
Price Discrimination in Action: Segmenting the Market
Cost & Price
Output (Q)
Market A Market B
AR
MR
MR
AR
LRAC = LRMC LRAC = LRMC
P13
Cost & Price
Output (Q)
Price Discrimination in Action: Segmenting the Market
Cost & Price
Output (Q)
Market A Market B
AR
MR
MR
AR
LRAC = LRMC
P1
Q1
LRAC = LRMC
P13
Cost & Price
Output (Q)
Price Discrimination in Action: Segmenting the Market
Cost & Price
Output (Q)
Market A Market B
AR
MR
MR
AR
LRAC = LRMC
P1
Q1
LRAC = LRMC
Supernormal
profit
P13
Cost & Price
Output (Q)
Price Discrimination in Action: Segmenting the Market
Cost & Price
Output (Q)
Market A Market B
AR
MR
MR
AR
LRAC = LRMC
P1
Q1
LRAC = LRMC
Supernormal
profit
Q2
Supernormal
profit
P2
P13
Cost & Price
Output (Q)
Price Discrimination in Action: Segmenting the Market
Cost & Price
Output (Q)
Market A Market B
AR
MR
MR
AR
LRAC = LRMC
P1
Q1
LRAC = LRMC
Supernormal
profit
Q2
Supernormal
profit
P2
P3
P3 prices this
group out of
the market
P3
P13
Evaluation Question
Evaluate the view that
a strategy of price
discrimination by a
producer always works
more in the interests
of producers rather
than consumers and
society as a whole
P14
Pricing in interests of producers
Exploitation of the consumer the
majority still pay > marginal cost
Extraction of consumer surplus turned
into higher producer surplus / profit
Possible use as a limit pricing tactic /
and a barrier to entry
Reinforces the monopoly power /
dominance of existing firms
P14
Pricing in interests of producers
Exploitation of the consumer the
majority still pay > marginal cost
Extraction of consumer surplus turned
into higher producer surplus / profit
Possible use as a limit pricing tactic /
and a barrier to entry
Reinforces the monopoly power /
dominance of existing firms
P14
Pricing in interests of producers
Exploitation of the consumer the
majority still pay > marginal cost
Extraction of consumer surplus turned
into higher producer surplus / profit
Possible use as a limit pricing tactic /
and a barrier to entry
Reinforces the monopoly power /
dominance of existing firms
P14
Pricing in interests of producers
Exploitation of the consumer the
majority still pay > marginal cost
Extraction of consumer surplus turned
into higher producer surplus / profit
Possible use as a limit pricing tactic /
and a barrier to entry
Reinforces the monopoly power /
dominance of existing firms
P14
Evaluation: Counter-arguments
Potential for cross subsidy of
activities that bring social benefits
Making better use of spare capacity
Bringing some new consumers into
market otherwise excluded by price
Use of monopoly profit for research
this is a stimulus to innovation
P14
Evaluation: Counter-arguments
Potential for cross subsidy of
activities that bring social benefits
Making better use of spare capacity
Bringing some new consumers into
market otherwise excluded by price
Use of monopoly profit for research
this is a stimulus to innovation
P14
Evaluation: Counter-arguments
Potential for cross subsidy of
activities that bring social benefits
Making better use of spare capacity
Bringing some new consumers into
market otherwise excluded by price
Use of monopoly profit for research
this is a stimulus to innovation
P14
Evaluation: Counter-arguments
Potential for cross subsidy of
activities that bring social benefits
Making better use of spare capacity
Bringing some new consumers into
market otherwise excluded by price
Use of monopoly profit for research
this is a stimulus to innovation
P14
Smart Analysis: Huge market growth
P15
Falling prices for smartphones
According to one forecast,
the global smartphone
market will grow 34 per
cent over the next twelve
months with sales of 285m
units in 2013 but average
selling prices of
smartphones will fall 9 per
cent to $273.
P15
Smartphone Market Share (2012)
Samsung 22%
Nokia 19%
Apple 5%
RIM (Blackberry)
2%
HTC 4%
Smartphone
Market Share (%
of Global Sales,
Q3 2012)
Cost & Price
Output (Q)
Smartphones A Decreasing Cost Industry?
Internal Economies of Scale
and the Price of Smartphones
AC1
AC2
MC1
MC2
AR
MR
Profit maximising price when costs
are high is P1 and Q1

P1
Q1
P15
Cost & Price
Output (Q)
Smartphones A Decreasing Cost Industry?
Internal Economies of Scale
and the Price of Smartphones
AC1
AC2
MC1
MC2
AR
MR
Profit maximising price when costs
are high is P1 and Q1

When economies of scale are
achieved, the profit-maximising
price falls to P2 and output
expands to Q2

P1
Q1
P2
Q2
P15
Cost & Price
Output (Q)
Smartphones A Decreasing Cost Industry?
Internal Economies of Scale
and the Price of Smartphones
AC1
AC2
MC1
MC2
AR
MR
Profit maximising price when costs
are high is P1 and Q1

When economies of scale are
achieved, the profit-maximising
price falls to P2 and output
expands to Q2

Economies of scale mean lower
prices for consumers

And higher profits for
manufacturers of smartphones!



P1
Q1
P2
Q2
C2
Supernormal
profit!
P15
Smartphones A Decreasing Cost Industry?
Cost & Price
Output (Q)
External Economies of Scale in
Smartphone industry
LRAC1
External economies of scale (EEoS)

When the long-term expansion of
an industry leads to the
development of ancillary services
which benefit suppliers in the
industry

Industry expertise / skilled
labour
Relocation of key supply
businesses
Investment in infrastructure
Links with universities and
other research businesses

P15
Smartphones A Decreasing Cost Industry?
Cost & Price
Output (Q)
External Economies of Scale in
Smartphone industry
LRAC1
External economies of scale (EEoS)

When the long-term expansion of
an industry leads to the
development of ancillary services
which benefit suppliers in the
industry

Industry expertise / skilled
labour
Relocation of key supply
businesses
Investment in infrastructure
Links with universities and
other research businesses

LRAC1 with external
economies of scale
P15
What factors other than
cost might help to explain
why average selling prices
of smartphones are
expected to fall by nearly
10 per cent in 2013?
Intense competition Emerging Markets
Substitute Devices Satisficing Behaviour
P15
Monopsony Power in Markets
P16
Effects of Monopsony on Welfare
Monopsony power
1: Food retailers
2: Electricity generators
3: Coffee / cocoa roasters
4: Amazon / Apple
5: National Health Service
P16
Authors/Agents
Wholesalers
Retailers
Consumers
Publishers/Distributors
Bookstores
Chains
Independent
Bookstores
Supermarkets
Internet
Retailers
Book Clubs
The Book Market Supply Chain
monopsony power for major buyers
P16
Amazon Market Power

Volume Value
% %
Chain bookshops* 29 36
Independent bookshops 4 5
Bargain bookshops 9 4
Supermarkets 13 10
Other shops 12 8
Book clubs 6 6
Internet-only retailers# 27 31
* Waterstones, WHSmith, Blackwell
# Internet only e.g. Amazon, Play.com

Internet Only Book Sales
in UK (2011)
Market
share
Amazon 70%
The Book Depository 4-5%
Play.com 3-4%
Others (including
publishers direct)
22%
P16
Amazon and Monopsony Power
Application: How does
Amazon gain from
monopsony power?
1: Cheaper prices from
publishers
2: Charge a premium for
sellers on Market Place
3: Ability to under cut
other book retail channels
Amazon and Economies of Scope
Amazon launched its
groceries range,
which includes tea,
pasta and biscuits, in
July 2010 with little
more than 22,000
products. However, it
now offers in excess
of 150,000 products,
from crisps to
nappies, which are
typically sold in bulk,
as it attempts to
gobble up sales from
the high street
The effect of monopsony on welfare
Evaluation: What can producers do if
faced with monopsony power?
1: Form co-operatives
2: Lobby competition authorities
3: Build their own retail channels
e.g. small bookshops going online
P16
Monopsony Power in Labour Markets P17
Wage
Labour
(Employment)
Monopsony Power in Labour Markets Lower Wages?
Monopsony Employer
MC labour
Labour
Demand
(MRPL)
Labour
supply
Profit maximising employment
level is where MRPL = MC labour

This gives employment of E1 the
marginal revenue product is W1

But employer needs only pay an
average weekly wage of W2 to
hire these workers

Monopsony employer using their
buying wage to pay wages below
the fair value of output from their
employees

An abuse of market power?
A cause of relative poverty?
W1
W2
E1
P17
Monopsony Power in Labour Markets Minimum Wages
Wage Possible Effects of a Minimum Wage
Labour
(Employment)
MC labour
Labour
Demand
(MRPL)
Labour
supply
Minimum wage is a pay floor

Minimum hourly pay rate

Must be set above usual free
market wage

Monopsonist must pay this wage

Employment rises to E2

More people employed at a higher
wage

Other factors affecting wages are
held constant in this analysis

Min
Wage
E2
W2
E1
P17
Download all of todays
resources, including
suggested answers from
www.tutor2u.net/a2micro2012.pdf
Session 3
The Economics
of Oligopoly
P19
Oligopoly Behaviour
Main characteristics of an oligopoly
Best defined by the actual behaviour of firms
A market dominated by a few large firms
High market concentration
Each firm supplies branded products
Barriers to entry
Interdependent decisions
P19
Oligopoly (O), duopoly (D) or a highly
competitive (C) market you decide!
Household detergent
suppliers in the UK
UK High Street Banks
Plumbers and decorators in
Manchester
P19
Oligopoly (O), duopoly (D) or a highly
competitive (C) market you decide!
Producers of liquefied gas
(worldwide)
Aircraft manufacturing (worldwide)
Retail pharmacies / chemists
Parcel delivery market in London
P19
Pharmacies in Bristol
Pharmacies in
central
Birmingham
Cost & Price
Output (Q)
The Kinked Demand Curve Model
MR AR
MC
P1
Q1
Importance of Non-Price
Competition in Oligopoly
Price stickiness observed in oligopoly

Price may remain close to P1

Non price competition important in
growing / protecting market share

Lots of different examples of non-
price competition evident in this
market structure


P20
Cost & Price
Output (Q)
Non-Price Competition is key to market share and profitability
MR AR
MC
P1
Q1
Non-Price Competition in Oligopoly
Innovation Quality of service
Upgrades Exclusivity
P20
Oligopolistic Energy Market in the UK
Three million EDF Energy customers
will see their gas and electricity bills
rise by nearly 11 per cent on average
from December 7. The company, which
is blaming high wholesale energy costs
for the price rise, is the fifth major
energy firm to announce an increase in
recent months, following Scottish
Power, nPower, British Gas and SSE.
P20
Overt collusion
P21
What is meant by tacit collusion?
P21
What are the main aims of price fixing
by firms in an oligopoly?
Businesses recognise their interdependence and
act together aim to maximise joint profits
Cut the costs of competition e.g. wasteful
advertising / marketing wars
Reduces uncertainty higher profits increases
producer surplus / shareholder value
P21
Pricing Fixing
Cost & Price
Output (Q)
Price-Fixing Cartel in an Oligopoly
Cost & Price
Output (Q)
Industry Demand and Costs Cartel Price and the Individual Member
MC
MR AR
Q1
P1
P1 becomes cartel price
P21
P1
Q1
Cost & Price
Output (Q)
Price-Fixing Cartel in an Oligopoly
Cost & Price
Output (Q)
Industry Demand and Costs Cartel Price and the Individual Member
MC
MR AR
MC Firm A
AC Firm A
P1 becomes cartel price
P1
P21
P1
Q1
Cost & Price
Output (Q)
Price-Fixing Cartel in an Oligopoly
Cost & Price
Output (Q)
Industry Demand and Costs Cartel Price and the Individual Member
MC
MR AR
MC Firm A
AC Firm A
P1 becomes cartel price
P1
Output
quota for
firm
P21
P1
Q1
Cost & Price
Output (Q)
Price-Fixing Cartel in an Oligopoly
Cost & Price
Output (Q)
Industry Demand and Costs Cartel Price and the Individual Member
MC
MR AR
MC Firm A
AC Firm A
P1 becomes cartel price
P1
Output
quota for
firm
C1
Super-normal
profit for this
firm in the cartel
Profit at
cartel price
and staying
within the
quota
P21
P1
Q1
Cost & Price
Output (Q)
Price-Fixing Cartel in an Oligopoly
Cost & Price
Output (Q)
Industry Demand and Costs Cartel Price and the Individual Member
MC
MR AR
MC Firm A
AC Firm A
P1 becomes cartel price
P1
Output
quota for
firm
C2
Cheating
exceeding
the quota
Higher profit
from producing
in excess of the
output quota
Increasing
output to
achieve
higher
profits
P21
P1
Q1
Cost & Price
Output (Q)
Price-Fixing Cartel in an Oligopoly
Cost & Price
Output (Q)
Industry Demand and Costs Cartel Price and the Individual Member
MC
MR AR
MC Firm A
AC Firm A
P1 becomes cartel price
P1
Output
quota for
firm
C2
Cheating
exceeding
the quota
RISK!
Over-supply
threatens
stability of
cartel
P21
Why are many producer cartel agreements
unstable and tend to collapse or break down?
Falling market demand Over-production
Exposure by authorities Entry of non-cartel firms
P21
Damages consumer welfare
Higher prices / lost consumer surplus
Hits lower income families
Absence of competition hits efficiency
X-inefficiencies / higher costs
Less incentive to innovate
Reinforces monopoly power
Harder for new businesses to enter
Economic cost of collusion
P21
Collusion can bring benefits
Industry standards
Pharmaceutical research
Car safety technology
Fair Prices for producer cooperatives
Competing with monopsonistic corporations
Profits have value how are they
used?
Capital investment
P21
The Prisoners Dilemma
Prisoner B
Confess Deny
Prisoner
A
Confess (5,5) (1,10)
Deny (10.1) (2,2)
Comment on the best strategies for each
player and the likely outcome in this game
P22
Pricing Games
In this two firm game, each decides whether to
charge a low price or a high price
( profit) Firm B
Low Price 6 High price 8
Firm A Low price 6 (2, 2) (5, 1)
High price 8 (1, 5) (3, 3)
The dominant strategy for each player in this game is
to charge? Low Price / High Price
P23
Pricing Games
1. Does A have a dominant strategy?
2. Does B have a dominant strategy?
3. Is there Nash equilibrium in this game?
( profit or loss) Firm B
Low Price High price
Firm A Low price (1, 1) (3, -1)
High price (-1, 3) (4, 2)
P23
Game theory and entry deterrence
P23
Entry Deterrence in a Market
1. Does Firm A have a dominant strategy in this game?
2. If B enters the market does it charge a low or a high price?
3. Will the threat of A to charge a lower price deter firm B?
4. How can Firm A create a credible threat to firm B that
might prevent it from entering the market?
( profit or loss) Firm B
Enter market Do not enter
market
Firm A Low price 6 (3, -1) (3, 1)
High price 8 (4, 5) (6, 3)
Firm A is already in a market and can choose a low or a high price. Firm B is a
potential entrant / competitor in the market. The payoffs show the profits or
losses arising from decisions taken in the game
P23
Co-operation in Markets
Joint
Ventures
Industry
Standards
Open Source
Movement
Co-
operatives
P24
NETWORK SHARING
Vodafone
and
Telefonica
FUEL CELL RESEARCH
Toyota
and BMW
AIRLINES
Star
Alliance
P24
Business / Industry Co-operation
Gains from Co-operation
Productive
Efficiency
Dynamic
Efficiency
Poverty
Reduction
Social
Welfare
Gains
Ethical
Business
P24
Download all of todays
resources, including
suggested answers from
www.tutor2u.net/a2micro2012.pdf
Download all of todays
resources, including
suggested answers from
www.tutor2u.net/a2micro2012.pdf
Session 4
Competition Policy in
Action UK and
European Focus
P25
Economic Efficiency
P25
The main types of economic efficiency
Allocative Productive Dynamic
Competition Policy Overview
Sector / Industry Price caps for
wholesale prices?
Price caps for retail
prices?
Length of price
control period
Form of price
capping used
Water and sewerage No Yes Five years RPI + K
Telecommunications Yes caps on mobile
termination charges
(roaming fees)
No On-going no fixed
price capping
period
Long run
incremental cost
Electricity Yes price caps for
transmission and
distribution
No Five years, soon to
be eight years
RPI-X soon to be
RIIO
Gas Yes transportation
and distribution
No Five years, soon to
be eight years
RPI-X soon to be
RIIO
Postal Services Yes for pre-sort
services and prices
paid by non-Royal-
Mail businesses for
access to mail
network
Yes prices capped
periodic
increases in prices
allowed
Two-year price
freeze after a price
review large rise
in stamp prices in
2012
RPI-X for retail
postal charges but
this price control is
set to be abolished
P25
Judging Effectiveness of Regulation
Real prices Size of profits Jobs Performance
targets
Research
spending
Productivity Environmental
indicators
Investment in
new capacity
P25
Government Intervention
Explore the effects on
different stakeholders
(workers, managers,
customers, shareholders,
environment etc.)
BAA Case Study
P26
BAA and Airport Sales
P26
Airports close to capacity
Heathrow and Gatwick are two of the worlds busiest airports and both
operate very close to full-capacity. Explain what operating at near-capacity
might mean for their costs of production. Use an appropriate diagram if you
feel it helps your answer
P27
Price of
airport
landing
fees
Output (Q)
Volume of flights /
passengers
Airports Operating Close to Capacity
Reaching Capacity Limits
Supply
Demand
peak-times
Demand
off-peak
P27
Price of
airport
landing
fees
Output (Q)
Volume of flights /
passengers
Airports Operating Close to Capacity
Reaching Capacity Limits
Supply
Demand
off-peak
Demand
peak-times
P1 (off
peak)
P27
Price of
airport
landing
fees
Output (Q)
Volume of flights /
passengers
Airports Operating Close to Capacity
Reaching Capacity Limits
Supply
Demand
off-peak
Demand
peak-times
P1 (off
peak)
P2
(peak)
P27
Water Industry Economics
P28
Water prices and profits
Many regional water companies make high levels of profit.

Evaluate the view that high levels of profit in the water and sewerage supply
industry serves only the interests of producers rather than consumers.
P28
Price, Cost
Output (Q)
Water Industry Profits Using Double Diagrams
Price, Cost
Output (Q)
P1
Q1
MR
AR
MC
AC
C1
P29
Short Run
Monopoly
Price, Cost
Output (Q)
Water Industry Profits Using Double Diagrams
Price, Cost
Output (Q)
P1
Q1
MR
AR
MC
AC
C1
Monopoly
profit
P29
Short Run
Monopoly
Price, Cost
Output (Q)
Water Industry Profits Using Double Diagrams
Price, Cost
Output (Q)
P1
Q1
MR
AR
MC
AC
C1
Monopoly
profit
Consumer
surplus
Short Run
Monopoly
P29
Price, Cost
Output (Q)
Water Industry Profits Using Double Diagrams
Price, Cost
Output (Q)
P1
Q1
MR
AR
MC
AC
C1
Monopoly
profit
Consumer
surplus
Short Run
Monopoly
Long Run
Monopoly
AR
MR
LRAC
LRMC
P29
Price, Cost
Output (Q)
Water Industry Profits Using Double Diagrams
Price, Cost
Output (Q)
P1
Q1
MR
AR
MC
AC
C1
Monopoly
profit
Consumer
surplus
Short Run
Monopoly
Long Run
Monopoly
AR
MR
LRAC
LRMC
Q2
P2
C2
P29
Price, Cost
Output (Q)
Water Industry Profits Using Double Diagrams
Price, Cost
Output (Q)
P1
Q1
MR
AR
MC
AC
C1
Monopoly
profit
Consumer
surplus
Short Run
Monopoly
Long Run
Monopoly
AR
MR
LRAC
LRMC
Q2
P2
C2
Economies
of scale
Higher
profits
P29
EU Mobile Price Caps
P31
Capping Mobile Charges
Cost &
Price
Output (Q)
AC1
MC1
D=AR MR1
In the diagram below, draw in the unregulated profit maximising
price and output
P32
Cost &
Price
Output (Q)
AC1
MC1
D=AR MR1
In the diagram below, draw in the unregulated profit maximising
price and output
P1
Q1
P32
Profit max
price
Cost &
Price
Output (Q)
AC1
MC1
D=AR MR1
In the diagram below, draw in the unregulated profit maximising
price and output
P1
Q1
C1
Monopoly
profit
P32
Cost &
Price
Output (Q)
AC1
MC1
D=AR MR1
Where must a price cap be set to have any impact on the market?
Draw this onto your diagram
P1
Q1
Price Cap (ceiling) Price Cap
P32
Cost &
Price
Output (Q)
AC1
MC1
D=AR
MR1
Where must a price cap be set to have any impact on the market?
Draw this onto your diagram
P1
Q1
Price Cap
Q2
P32
Price Cap (ceiling)
Cost &
Price
Output (Q)
AC1
MC1
D=AR
MR1
Where must a price cap be set to have any impact on the market?
Draw this onto your diagram
P1
Q1
Price Cap
Q2
Lower price leads to an
expansion of demand
P32
Price Cap (ceiling)
Cost &
Price
Output (Q)
AC1
MC1
D=AR
MR1
Price caps (ceteris paribus) lead to lower profit margins
P1
Q1
Price Cap
Q2
Lower price leads to an
expansion of demand
C2
Cut in profit
per unit
P32
Price Cap (ceiling)
Evaluating Price Caps in Markets
Benefits
A surrogate for
competition
Holds prices
down consumer
welfare gains
Incentives to cut
costs to maintain
profits
Downsides
Reduces profits
and incentive to
invest
May dissuade
new entrants
Mobile firms
might raise prices
in other ways
Alternatives might
work better
Measures to
reduce entry
barriers
Higher taxes on
monopoly profits
P33
Mobile Profits
Evaluation in a Paragraph
Evaluation must relate to
the point / argument that
has already been made in
your paragraph
Aviation and Intervention
P34
Evaluation in a Paragraph
Evaluation should be
backed up with evidence
and/or knowledge to gain
full credit
Carbon Trading and Carbon Taxation - Business Impact P35
Recession
causes price of
permits to
collapse
Carbon price
recovers but
high enough to
make a
difference?
2012 price stuck
below Euro 10 per
tonne excess
supply of carbon
permits
Price of
carbon
permit
Quantity of permits
(1 permit = 1 tonne
CO2)
Carbon Trading and Carbon Taxation - Business Impact
Carbon Trading Market
Supply of
Permits
Euro 20
Q1
Demand for
Permits
P35
Price of
carbon
permit
Quantity of permits
(1 permit = 1 tonne
CO2)
Carbon Trading and Carbon Taxation - Business Impact
Carbon Trading Market
Supply of
Permits
Euro 20
Q1
Demand for
Permits
D2
Euro 30
P35
Price of
carbon
permit
Quantity of permits
(1 permit = 1 tonne
CO2)
Carbon Trading and Carbon Taxation - Business Impact
Carbon Trading Market
Supply of
Permits
Euro 20
Q1
Demand for
Permits
D2
Euro 30
Q2
S2
Euro 35
P35
Carbon Trading and Carbon Taxation - Business Impact
Cost, Price The Effect of a Carbon Tax on Producers
Output (Q)
MC
MR
AR
AC
P35
Carbon Trading and Carbon Taxation - Business Impact
Cost, Price The Effect of a Carbon Tax on Producers
Output (Q)
MC
MR
AR
AC
AC2
MC2
P35
Carbon Trading and Carbon Taxation - Business Impact
Cost, Price The Effect of a Carbon Tax on Producers
Output (Q)
MC
MR
AR
AC
AC2
MC2
Q1 Q2
P1
P2
P35
Costs,
Benefits
Output (Q)
Volume of flights
Externalities in the Airline Industry
By 2020, global international aviation
CO2 emissions are projected to be
around 70% higher than in 2005
even if fuel efficiency improves by
2% per year.

Direct emissions from aviation
account for about 3% of the EUs
total greenhouse emissions.

Including aviation in the EU
emissions trading scheme is forecast
to save around 176 million tonnes of
CO2 emissions over the period up to
2015.
MPC
MPB
P35
Costs,
Benefits
Output (Q)
Volume of flights
Externalities in the Airline Industry
MPC
MPB
MSC
Qp
P35
Using an appropriate diagram
explain how the EU airline industry
leads to a divergence between
private and social costs and benefits

Externalities are third party
effects arising from production
and consumption of goods and
services for which no appropriate
compensation is paid
Costs,
Benefits
Output (Q)
Volume of flights
Externalities in the Airline Industry
MPC
MPB
MSC
External Cost
Qp
P35
Using an appropriate diagram
explain how the EU airline industry
leads to a divergence between
private and social costs and benefits

Externalities are third party
effects arising from production
and consumption of goods and
services for which no appropriate
compensation is paid

Costs,
Benefits
Output (Q)
Volume of flights
Externalities in the Airline Industry
MPC
MPB
MSC
External Cost
Qp Qs
Social
Optimum
Output
P35
Free market equilibrium (at Qp) is
different from the social optimum

(we are not showing possible
positive externalities from
consumption here)

Market failure when the market price
fails to take into account the external
costs
Evaluate the argument that participation in the EU carbon
trading scheme is likely to be most effective policy for reducing
carbon emissions from the European airline industry
The EU brought in the Emissions Trading
Scheme for airlines on 1 January. This
applies to internal flights, that begin and
end within the 27-country single market
Aircraft using airports within the EU must
pay a tax on each tonne of CO2 emitted.
The airlines have said that this will cost
them 14.0bn over eight years
P36
Evaluate the argument that participation in the EU carbon trading scheme is
likely to be most effective policy for reducing carbon emissions from the
European airline industry
P36
Explain &
Analyse
Carbon
Trading
Conditions
for carbon
trading to be
effective
Critical
evaluation
problems
with trading
Viable
alternatives
more
effective?
Knowledge
Analysis
Analysis
Evaluation
Evaluation
Evaluate the argument that participation in the EU carbon trading scheme is
likely to be most effective policy for reducing carbon emissions from the
European airline industry
P36
Trading puts a price on carbon
Incentivises airlines to reduce their emissions
Stimulates investment in new aircraft
A boost to innovation / dynamic efficiency
Revenues can be ring-fenced for green projects
Arguments
for a carbon
trading
scheme
Evaluate the argument that participation in the EU carbon trading scheme is
likely to be most effective policy for reducing carbon emissions from the
European airline industry
P36
Collapse of EU carbon price makes it ineffective
Imposes extra costs on EU airlines already struggling
Government failure e.g. fraud from allocating permits
Might cost jobs in an important industry for the EU
Variable / uncertain price of carbon limits incentive to invest
Criticisms of
carbon
trading
In the long run..
Strong evaluation might
compare short run v long
run effects from a policy
intervention
Evaluate the argument that participation in the EU carbon trading scheme is
likely to be most effective policy for reducing carbon emissions from the
European airline industry
P36
Carbon or fuel taxation gives more certainty
Tougher industry regulations
Tax incentives for innovation
Market forces work in long run
Global approach needed to cut emissions
Alternatives
and a Long
Run
Perspective
The Knowledge
Students with current
knowledge invariably
outscore those who dont
true for micro and macro!
Download all of todays
resources, including
suggested answers from
www.tutor2u.net/a2micro2012.pdf
Session 5
Improving your exam
technique and scores
in the A2 micro paper
P37
Quick Advice on EdExcel Unit 3
P37
Quick Advice on EdExcel Unit 3
1. Define term
2. Explain answer
3. Draw or annotate diagram
4. One knock-out (rejection)
P37
Another structured MC example
P38
Another structured MC example
1. Define term
2. Explain answer
3. Draw or annotate diagram
4. One knock-out (rejection)
1. Revenue maximised when MR = zero
2. Unsold flowers can be offered at a price
discount to run down stocks. This is a form
of second-degree price discrimination
3. Likely to be elastic demand, flowers have
to be disposed of anyway
4. Draw a diagram to illustrate. P1 is profit
maximising price, P2 is a revenue
maximising price Q1-Q2 sold at the
lower price adding to revenue
5. One knock-out, predatory pricing is illegal
in UK

Price
Qty
MC
AR
MR
P1
Q1 Q2
P2
P38
Building a Good Answer
Introduction
Paragraph
Points
Conclusion
An effective paragraph..
Makes 1 relevant point
to an
appropriate depth
= 6 to 8 sentences
Explain how both a firm and its consumers may be
affected by economies of scale
P40
Explain how both a firm and its consumers may be
affected by economies of scale
P40
Explain how both a firm and its consumers may be
affected by economies of scale
Define
your terms
Internal EoS
External EoS
Internal
Economies
Falling long run
unit cost
Increasing
returns to scale
External
Economies
Growth of an
industry
Lowers unit costs
for most
businesses
P40
Explain how both a firm and its consumers may be
affected by economies of scale
Analyse
Good diagram
Bring in MES
Impact on
firms
Lower average
cost from rising Q
Higher profits
(producer surplus)
Impact on
consumers
Reduction in real
prices
Increased
affordability
consumer surplus
No evaluation
needed in this
question!
P40
Explain how both a firm and its consumers may be
affected by economies of scale
Price
Output (Q)
Economies of Scale Benefits
for Businesses and Consumers
LRAC
AR =
demand
P40
Explain how both a firm and its consumers may be
affected by economies of scale
Price
Output (Q)
Economies of Scale Benefits
for Businesses and Consumers
LRAC
AR =
demand
P1
C1
Profit at
output Q1
Q1
P40
Explain how both a firm and its consumers may be
affected by economies of scale
Price Economies of Scale Benefits
for Businesses and Consumers
LRAC
AR =
demand
P1
C1
P2
C2
Q1 Q2
Profit at
output Q1
Profit at
output Q2
P40
Explain how both a firm and its consumers may be
affected by economies of scale
Price Economies of Scale Benefits
for Businesses and Consumers
LRAC
AR =
demand
P1
C1
P2
C2
Q1 Q2
Profit at
output Q1
Profit at
output Q2
Gain in
consumer
surplus
P40
Explain how both a firm and its consumers may be
affected by economies of scale
Price Economies of Scale Benefits
for Businesses and Consumers
LRAC
AR =
demand
P1
C1
P2
C2
Q1 Q2
Profit at
output Q1
Profit at
output Q2
Gain in
consumer
surplus
Economies of scale have
the potential to benefit
both producers and
consumers higher
profits and lower prices
P40
Explain how both a firm and its consumers may be
affected by economies of scale
Price Economies of Scale Benefits
for Businesses and Consumers
LRAC
AR =
demand
P1
C1
P2
C2
Q1 Q2
Profit at
output Q1
Profit at
output Q2
Gain in
consumer
surplus
LRAC2
External
economies of
scale here
P40
Discuss whether utilities such as train operating companies, water, and
telecoms businesses are better left in the private sector or whether all, or
some, should be taken back into public ownership
Deeper evaluation (4+1 approach)
Outline (explain/analyse) and then evaluate 4 separate points with a brief final
reasoned evaluative paragraph
1/ Case for
private sector
Profit
motive
Dynamic
efficiency
2/ State
ownership
option
Objectives?
Outcomes?
3/ Impact on
stakeholders
Consumers
Employees
Taxpayers
4/ Alternatives
to public
sector
Competition
policy
Business
taxation
Evaluate the case for stronger action by governments to protect
consumers from the monopoly power of firms involved in
supplying gas and electricity to UK homes and businesses
Please note
the error in
the workbook
Significant rise in average energy bills in the UK this is a
major policy issue directly affects millions of consumers
and businesses.
Evaluate the case for stronger action by governments to protect
consumers from the monopoly power of firms involved in
supplying gas and electricity to UK homes and businesses
Please note
the error in
the workbook
Build the
economic
case for
action
High prices /
allegations
of collusion
Tougher
price caps?
Create
competition
in the
wholesale
market?
Supernormal
profits
Windfall Tax
on profits
State
Ownership
Rising fuel
poverty /
complex
prices
Cheapest
tariff as
default
Using
windfall tax
to fund
insulation
One main point per paragraph
Build an argument, support, then evaluate
Evaluation must relate to the point that has already been made
Evaluation
1. Large barriers to entry
2. Huge economies of scale
3. Limited contestability is a
feature of the market
Evaluation
1. Abnormal profits used to
fund capital investment
2. Long term energy security
3. Nationalisation &
inefficiency
Evaluation
1. Fewer tariffs but higher
average prices
2. Windfall tax discourages
investment & research
3. Government failure when
using revenues
Download all of todays
resources, including
suggested answers from
www.tutor2u.net/a2micro2012.pdf