Costs, revenues, profits and market structures

The exam

Costs

Revenue, Profit

Market structures

1 HOUR 30 MINUTES LONG- 40% A2- TOTAL 72 MARKS

Supported choice:

8 questions for 4 marks each

Total 32 marks

Spend no longer than 40 minutes here

Data question:

50% evaluation

4 questions

Total 40 marks

Spend 50 minutes here

The supported choice:

Definition: 1 mark

Diagram: 1 – 3 marks

Annotation: 1 mark

Application/calculation: 1 – 2 marks

Further analysis: 1 – 2 marks

KOs – 1 – 2 marks

The data response:

4 mark question

▪ purely knowledge AND application marks

▪ remember to apply your knowledge to the industry in the extract

8 mark question

▪ 4 marks for identification, explanation and analysis

▪ 4 marks for evaluation – 2 good evaluation points

The data response:

12 mark question ▪ Definition/knowledge – 1 mark

▪ Application, analysis & diagram – 5 marks

▪ 6 marks for evaluation

16 mark question ▪ 8 marks for identification, explanation and analysis

▪ 8 marks for evaluation – (2 + 2 + 2 + 2) safest

USE THE EXTRACT AND APPLY TO THE INDUSTRY IN QUESTION

Evaluation ideas:

Short versus long-run Different elasticities Magnitude of factors – use extract or data Ceteris paribus – could other factors be the cause of

these effects Challenge the data/absence of data to form a view Opposing viewpoints Put the event in a wider context

USE THE EXTRACT AND APPLY TO THE INDUSTRY IN QUESTION

Basics

Fixed costs: Costs which do not vary with level of output. Fixed costs apply to fixed factors of production (eg rent on shop owned by dry cleaner). In LR all factors are variable, so all costs are variable in LR

Variable costs: Costs which vary with the level of production (eg electricity usage by dry cleaner)

Sunk costs : A cost that a firm must incur to enter a market which cannot be recovered if the firm leaves that market. NB not all fixed costs are sunk costs as some can be recovered.

Shut down point – Firm needs to cover variable costs. You must be able to explain in words and diagrammatically

Reduction in LRAC that a firm enjoys as it increases the SCALE of its output

NB. Ec of scale are LONG RUN factors. You need to know a number of economies of

scale and disceconomies of scale MES. Lowest level of output consistent with

lowest LRAC.

OutputO

Co

sts

LRACEconomiesof scale

Constantcosts

Diseconomiesof scale

Total Revenue: Price x Q Average revenue : TR/Q (so the same as

price) Marginal Revenue: Change in TR from a one

unit change in output

PeD & revenue:

-4

-2

0

2

4

6

8

1 2 3 4 5 6 7

Elasticity = -1

TR= MAX

Elastic

Increase in Q increases TR

Inelastic

Increase in Q decreases

TR

AR

, M

R (

£)

Quantity

MR

AR

Normal profit is included within total costs. Therefore if a firm has TC = TR it is still

making normal profits If a firm failed to make normal profits it would

cease production of that good in the long run. The firm’s resources have a high opportunity

cost and could be put to better use producing other goods and services where a normal profit could be earned

Abnormal or economic or supernormal profit is profit over and above the normal profits.

If TR> TC then abnormal profits are earned.

-8

-6

-4

-2

0

2

4

6

8

10

12

14

16

18

20

22

24

1 2 3 4 5 6 7

TR

, T

C, TP

(£)

TP

TR

TC

d

e

f

Quantity

The four market structures

Type of

market

Number

of firms

Freedom of

entry

Nature of

product

Examples Implications for

demand curve

faced by firm

Perfect

competition

Very

many UnrestrictedHomogeneous

(undifferentiated)

Cabbages, carrots

(approximately)

Horizontal:

firm is a price taker

Monopolistic

competition

Many /

severalUnrestricted Differentiated Builders,

restaurants

Downward sloping,

but relatively elastic

Oligopoly Few Restricted

Undifferentiated

or differentiated

Cement

cars, electrical

appliances

Downward sloping.

Relatively inelastic

(shape depends on

reactions of rivals)

Monopoly One Restricted or

completely

blocked

Unique

Local water

company, train

operators (over

particular routes)

Downward sloping:

more inelastic than

oligopoly. Firm has

considerable

control over price

Qe

P1

D1 = AR1

= MR1

AR1

O O

(a) Industry

P £

Q (millions)

S

D

(b) Firm

MC AC

AC

Q (thousands)

Loss is minimised

where MC = MR.

Qe

P1

D1 = AR1

= MR1

AR1

O O

(a) Industry

P £

Q (millions)

S

D

(b) Firm

MC

AC

AC

Q (thousands)

Loss is minimised

where MC = MR.

£

Q O

MC

AC

Qm

MR

AR

AC

AR

Total profit

Profit

Price

0 Quantity

Deadweight

loss

Demand=AR

MR

Consumer

surplus

Qm

Monopoly

price

MC=AC

A

B

C

Qc

£

Q O Qs

AR = D

MC

AC

MR

Ps

ACs

ARL = DL

MRL

£

Q O QL

PL

LRAC

LRMC

New firms entering

the industry reduce

demand for each

individual firm.

Price falls to PL

Q2

P2DL under perfect

competition

£

QO

P1

LRAC

DL under monopolistic

competition

Q1

Higher price and lower output

(excess capacity) under

monopolistic competition

Demand curve will be more elastic in monopcomp

Abnormal profits only in the SR

But both are productively and allocativelyinefficient....

Monop comp firms will need to engage in much more non-price competition

quantity

£

D=AR

MR

Q*

P*

£

D

MRQ*

P*

MC

MC’This price rigidity is seen in real world oligopoly markets.egChauffeur cars with virgin atlantic;“Free” blue- tooth on your new car

BHigh price Low price

High price

A

(100,100) (50,120)

Low price(120,50) (80,80)

Both firm A and firm B have a dominant strategy of selling at a low price and so are most likely to earn £80m each. However through collusion they would both be better off and earn £100m.

Concentration ratios are high – this makes it easier to form agreements and to detect defectors

Costs are similar – this allows pricing to be similar and reduces the incentive for low cost firms to undercut other potential cartel members

Similar products – as there is less to be gained from non-price competition

Slow technological change – this limits new entrants into the market and so makes an existing cartel able to enjoy long-run supernormal profits

Inelastic and stable demand – an increase in price will allow cartel members to enjoy higher revenue and so hopefully higher profits

The size of entry and exit barriers – lower entry and exit barriers attract new entrants and so could potentially compete with higher prices in the cartel. Thus contestability is key.

There’s an incentive to break the agreement and produce more than expected at lower prices (profit maximising output is higher than their quota). This is shown above where if firm A charges a low price and firm B a high one, firm A makes £120m, which is better than £100m in the cartel or £80m through ordinary competition. For a firm to collude, there must be an effective punishment strategy to prevent this from happening.

Bigger problem if there are more firms as individual market shares are smaller and so the potential for large gains are greater. It will also make detection harder . Overall effect depends on the ease and speed with which cheating can be detected. This problem can become greater if new firms enter the market and so undermine the monopoly power of the cartel.

Disagreement over the extent to which the cartel should raise prices when they are colluding. Higher prices in the short-run attract more entrants and so make it harder to maintain a cartel whereas slightly lower prices could mean more sustained long-run profits as market entry is relatively less attractive.

OFT regards cartels as “a particularly damaging form of anti-competitive behaviour, where fines for being a cartel member can be up to 10% of a firm’s UK turnover/criminal sanctions. Firms can blow the whistle on cartels eg Virgin/ BA, and so receive reduced OFT sanctions.

Falling market demand – this creates spare capacity and puts pressure on firms to cut prices in order to maintain revenue.

Cartels may also not be deliberate but may be tacit instead. This is where firms behave as though in a cartel but they have not actually communicated and established one. Thus they act in each other’s mutual interest and restrict competitive actions.

This often happens when there is a price leader, or dominant firm in the industry, perhaps in terms of size or cost advantage. The dominant firm will set the price and allow the other firms to supply as much as they want at this price. The dominant firm, who has lower costs, can then supply the residual.

Motives of a firm Profit Maximising MC=MR

Sales Maximisation AC=AR

Revenue Maximisation MR=0; TR=MAX

Allocative efficiency P=MC

Productive efficiency Min AC You must be able to show these on a diagram

or be able to identify these on a diagram drawn for you.

What if a loss is made?

loss minimising: still produce where MR = MC

short-run shut-down point:P = AVC

Why is this shut down point?

Because the firm has to cover its variable costs. It is rational to continue producing in the short run if it does not cover its fixed costs because fixed costs have to be paid and the firm cannot alter them in the short run. But it must cover its variable costs.

Growth by merger and take over (horizontal, vertical, conglomerate)

motives for mergers

▪ growth

▪ economies of scale

▪ monopoly power

▪ for increased market valuation

▪ to reduce uncertainty

▪ other motives

relationship between growth and profit

Satisficing and the setting of targets

Managers may not maximise a particular objective (eg profit) but instead set a target that they wish to achieve and then pursue their own goals (nice office; nice company cars; leisure pursuits...)

Divorce of ownership (shareholders) and control (managers) makes this more likely. Principal-Agent problem.

conflicts between targets..unlikely that such a firm’s price and output decision are those of a profit maximising firm.

organisational slack + economic inefficiency (all forms of it) are likely