This document provides an overview of business objectives and the growth of firms. It discusses that while private businesses seek profit, public sector businesses are state-owned. It also notes that businesses have a range of objectives beyond just profit maximization, including increasing market share, revenue maximization, and pursuing ethical goals. The document then examines reasons why businesses may depart from pure profit maximization, such as imperfect information, being multi-product firms, and behavioural theories where different stakeholders have varying objectives. Alternative objectives that businesses may pursue include satisficing behavior, sales revenue maximization, and managerial satisfaction models.

1. A2 Microeconomics
Business Economics
Study Companion
GEOFF RILEY
10th
Edition - 2013

2. © Tutor2u Limited 2013 2
A2 Microeconomics Study Companion – 2013
I gratefully acknowledge the help given in the preparation of this study companion by my own students and I
also acknowledge some of the ideas and arguments put forward in articles written by Bob Nutter, Tom White,
Penny Brooks, Mark Seccombe, Mo Tanweer, Jim Riley, David Carpenter, Ben White, Liz Veal, Ruth Tarrant,
Ben Cahill, Ben Christopher and Mark Johnston
Table of Contents
1. Objectives of Businesses and the Growth of Firms ...............................................................................3
2. The Growth of Firms.............................................................................................................................7
3. Calculating the Revenue of a Firm ......................................................................................................16
4. Calculating a Firm’s Costs..................................................................................................................18
5. Production in the Short and the Long Run...........................................................................................24
6. Long Run Costs: Economies of Scale.................................................................................................27
7. Diseconomies of Scale .......................................................................................................................37
8. Profits.................................................................................................................................................39
9. Divorce between Ownership and Control ............................................................................................47
10. Measuring Market Concentration ........................................................................................................49
11. Barriers to Entry and Exit in Markets...................................................................................................52
12. Technological Change, Costs and Supply in the Long-run ..................................................................56
13. Perfect Competition – Economics of Competitive Markets...................................................................60
14. Monopolistic Competition....................................................................................................................67
15. Model of Pure Monopoly.....................................................................................................................69
16. Monopoly and Price Discrimination in Markets....................................................................................71
17. Monopoly and Economic Efficiency.....................................................................................................76
18. Oligopoly – Non Collusive Behaviour ..................................................................................................85
19. Oligopoly – Collusion between Businesses.........................................................................................92
20. Oligopoly - Game Theory....................................................................................................................96
21. Contestable Markets...........................................................................................................................99
22. Monopsony Power in Product Markets..............................................................................................105
23. Consumer and Producer Surplus......................................................................................................110
24. Summary on Market Structures ........................................................................................................113
25. Government Intervention – Competition Policy..................................................................................116
26. Government Intervention – Price Regulation.....................................................................................122
27. Government Intervention - Privatisation and Nationalisation..............................................................128
28. The Private Finance Initiative (PFI) ...................................................................................................134
29. Industry in Focus - Water..................................................................................................................137
30. Business Economics Glossary..........................................................................................................140

3. © Tutor2u Limited 2013 3
1. Objectives of Businesses and the Growth of Firms
Businesses supply goods and services to markets:
 Private sector businesses seek to make a commercial rate of return for the capital invested by their
shareholders. Examples of private sector businesses include the retailer Tesco the express parcel
and logistics operator FedEx, the bank Santander and the electronics corporation Samsung.
 Public sector businesses are wholly or part-state owned. Examples of public sector firms include
Network Rail, East Coast Trains and the Royal Mail.
The usual theory of the firm assumes that businesses have sufficient information, market power and
motivation to set prices for their products that maximise their total profits
 This assumption is criticised by economists who have studied the organisation and objectives of
modern-day corporations both large and small. Businesses have a much wider range of objectives
 Not only do most businesses frequently move away from pure profit-seeking behaviour, many are
deliberately organised and operate in a way where profit is not the only objective.
Examples of different business objectives
There will always be a range of business objectives. An increasing number of companies are refocusing their
priorities beyond profit and towards the welfare of their suppliers, employees and the planet.
1. Profit maximisation (this occurs where marginal revenue = marginal cost)
2. Revenue maximisation (this occurs where marginal revenue = zero)
3. Increasing and protecting market share
4. Breaking into a new market and making sufficient profit to remain there in the long run
5. Surviving a recession and/or a persistently slow recovery
6. Pursuing ethical business objectives (e.g. promoting corporate social responsibility)
7. Providing a public service – see later sections on nationalised (state-owned) industries
Why might a business depart from profit maximisation?
Some explanations relate to the lack of accurate information required to set profit maximising prices. Others
concentrate on the alternative objectives of businesses.
 Imperfect information:
o It might be hard for a business to pinpoint their profit maximising output, as they cannot
accurately calculate marginal revenue & cost
o Day-to-day pricing decisions are taken on the basis of “estimated demand” or “rules of
thumb”. Businesses can take advantage of their market experience when setting prices
o A business might look to add a profit margin on top of average cost – “cost-plus pricing”.
 Multi-product businesses:
o Most businesses are multi-product firms operating in a range of markets across countries
and continents – the volume of information that they have to handle can be vast. And they
must keep track of the ever-changing preferences of consumers.
o The idea that there is a neat, single profit maximising price is redundant

4. © Tutor2u Limited 2013 4
Maximisers and Satisficers
Maximisers behave in a traditional
economic way and always try to make the
best possible choice from the available
alternatives.
Satisficers examine only a limited set of
alternatives, and choose the best between
them
Source: Professor Paul Ormerod
Behavioural Theories of the Firm
Behavioural economists believe that large businesses are
complex organizations made up of different stakeholders – i.e.
groups made up of different people who each have a vested
interest in the activity of a business. Examples include:
o Managers employed by a business and other employees
o Shareholders – people who have a stake in a business
o Customers
o The government and it’s agencies
Each group is likely to have different objectives or goals at points
in time. The dominant group at any moment can give greater
emphasis to their own objectives – for example price and output
decisions may be taken at a local level by managers – with
shareholders taking only a distant view of the company’s
performance and strategy.
If firms are likely to move away from pure profit maximising
behaviour, what are the alternatives?
1. Satisficing behaviour is when businesses move away
from pure profit maximisation and choose instead to aim
for minimum acceptable levels of achievement in terms
of revenue and profit. Satisficing is when someone only
considers a limited number of alternatives
2. Sales Revenue Maximisation
 The objective of maximising sales revenue rather than profits was developed by William Baumol
whose work focused on the behaviour of manager-controlled businesses
 Baumol argued that annual salaries and perks are linked to sales revenue rather than profits
 Companies geared towards maximising revenue are likely to make extensive use of price
discrimination to extract extra revenue and profit from consumers. A firm might also aim to
maximise sales revenue rather than profits because it wishes to deter the entry of new firms
 If a firm decides to aim to maximise sales revenue rather than profits, one of the consequences
might be a reduction in the price of the firm’s shares
3. Managerial Satisfaction model
An alternative view was put forward by Oliver Williamson (1981), who developed the concept of managerial
satisfaction (or managerial utility)
 Assuming that the firm’s costs remain the same, a firm will choose a lower price and supply a higher
output when sales revenue maximisation is the main objective
 In the following diagram, the normal profit maximising price is P1 at output Q1 and the revenue
maximising price is P2 at output Q2
 Consumer surplus is higher with sales revenue maximisation because output is higher and price is
lower. Producer surplus is greater when profits are maximised

5. © Tutor2u Limited 2013 5
Edinburgh Bicycle Co-operative operates across eight
stores in Scotland and England as well as online and
has around 100 workers, each with an equal share in
the business
Diagram to show different objectives and different price and output combinations
Social Entrepreneurs / Social Enterprises
 A social business or a social enterprise is a business created to address a social problem or issue
that only makes enough profit to sustain itself
 Profits are reinvested for one or more social purposes in the community, rather than being driven by
the need to seek profit to satisfy investors
 Social entrepreneurs are looking to achieve social, cultural and environmental aims
 In the summer of 2013, research published found that there are currently 70,000 social enterprises in
the UK contributing £18.5bn to the economy and employing almost 1m people. They include Jamie
Oliver’s Fifteen restaurant chain and The Big Issue magazine sold by homeless people
Co-operative Businesses
 Co-operative businesses (Co-ops) are owned
and run by their members, who can be
customers, employees or groups of
businesses.
 The supermarkets-to-funerals Co-op Group is
the biggest, followed by John Lewis
Partnership, the retailer. Farmers’ co-ops are
also popular in the UK.
 Other co-ops include community pubs,
supporter-run football clubs and foster care
and childcare providers
 These types of business are founded and run
on principles of shared ownership, shared
voice and shared profits.
Costs
Output (Q)
AC
AR (Demand)
MR
MC
Q1
P1
AC1
Profit Maximized at Price P1
P2
AC2
Q2
Revenue Maximized at Price P2

6. © Tutor2u Limited 2013 6
Not for Profit Businesses
These are charities, community organisations that are run on
commercial lines e.g. Network Rail:
o Network Rail: Their stated purpose is to deliver a safe,
reliable and efficient railway for Britain
o It is a company limited by guarantee – whose debts are
secured by the government
o Network Rail operates as a commercial business and
regulated by the Office of Rail Regulation
o Network Rail is a "not-for-dividend" company - profits are
invested in the railway network.
o Train operating companies (TOCs) pay Network Rail for use
of the rail infrastructure
o They are given targets for punctuality and safety
Ethical Businesses – Corporate Social Responsibility
Corporate social responsibility happens when companies
integrate social and environmental concerns in their business
operations and in their interaction with their stakeholders on a
voluntary basis
Key reasons why firms are increasingly embracing CSR
 Altruism – being a good citizen
 Window-dressing to appease stakeholders
 Contracting benefits – e.g. helps recruit, motivate and
retain employees
 Customer-related motivation: attract customers; brand
positioning
 Lower production costs (packaging, energy usage)
 Risk management – address potential legal or
regulatory action
 Improved access to capital – for example, the rise
ethical investment funds looking to make equity
investments in companies with strong CSR reputations
Michael Porter - Shared Value and
the Limitations of CSR
Narrow views about how to create profit
has created disconnect between
businesses and society and needs to
change according to Harvard Business
School Professor Michael Porter.
“A growing number of companies known
for their hard-nosed approach to
business—such as GE, Google, IBM, Intel,
Johnson & Johnson, Nestlé, Unilever, and
Wal-Mart—have already embarked on
efforts to create shared value by looking
again at the intersection between
society and corporate performance.”
Shared value is creating economic value
by creating social value
In recent times, creating value has
tended to focus on short-termist thinking
- Businesses have been long on driving
huge sales and output volumes, downsize
and de-layering inefficient management
and generally responding to pressure
from financial markets to deliver
immediate results through cost-cutting,
dynamic pricing and increasingly tough
marketing that can often persuade
people to buy things that are not good
for them.
This involves a recalibration and a
rethinking about what a product really
is and what needs a business is meeting,
for example in the food industry,
products that are nutritious and healthy
rather than focus on volume, lower unit
costs and higher profits. He notes to
increasing prominence of social
entrepreneurs with revenue generating
business models.
Consumers looking at the world
differently and expressing their
preferences in strong ways - this is
already having a direct effect on
supermarket behaviour.

7. © Tutor2u Limited 2013 7
2. The Growth of Firms
Why do firms grow?
1. Profit motive:
a. Businesses grow to achieve higher profits and raise returns for their shareholders
b. The stock market valuation of a firm is influenced by expectations of future sales and
profit streams so if a company achieves disappointing growth figures, this might be reflected
in a fall in the share price. This then opens up the risk of a hostile take-over and makes it
more expensive for a quoted company to raise fresh capital by issuing new shares
2. Cost motive:
a. Economies of scale have the effect of increasing the productive capacity of the business
leading to lower long run average costs. They help to raise profit margins at a given price
3. Market power motive:
a. Firms may wish to increase market dominance giving them increased pricing power
b. This market power can be used as a barrier to the entry of new businesses
c. Larger businesses can build and take advantage of buying power (monopsony)
4. Risk motive:
a. Growth might be motivated by a desire to diversify production and/or sales so that falling
sales in one market might be compensated by stronger demand in another sector
b. This is known as achieving economies of scope and is a feature of conglomerates
5. Managerial motives: Behavioural theories of the firm predict that business expansion might be
accelerated by senior managers whose objectives are different from the major shareholders.
How do firms grow?
Organic Growth
Organic growth is also known as internal growth. It happens when a business expands its own operations
rather than relying on takeovers and mergers. Organic growth might come about from:
 Increasing existing production capacity through investment in new capital & technology
 Development & launch of new products
 Finding new markets for example by exporting into emerging countries
 Growing a customer base through marketing

8. © Tutor2u Limited 2013 8
External Growth
External growth takes place through mergers or take-overs.
There are many potential advantages:
 Faster speed of access to new product or market areas
 Increase market share / increased market power
 Access economies of scale (perhaps by combining
production capacity)
 Secure better distribution channels / control of supplies
 Acquire intangible assets (brands, patents, trademarks)
 Overcome barriers to entry to target markets
 Defend a business against a takeover threat
 Enter new segments of existing market
 To take advantage of deregulation in an industry
Horizontal integration: When two businesses in the same
industry at the same stage of production become one – for
example a merger between two car manufacturers or drinks
suppliers. Recent examples of horizontal integration include:
 Cadbury buying Innocent Smoothies
 Cadbury was bought by the American Kraft Foods
in 2010. It was then spun off into Mondelez
International - Kraft Group's international snack
and confectionary business
 Lloyds Banking Group taking over HBOS
 Tata buying Jaguar Land Rover from Ford Motors
 Iberia and BA merger
 Costa Coffee (Whitbread) buying Coffee Nation
 Volkswagen buying Porsche
 Arla, the Swedish-Danish dairy co-operative
merged with British co-op Milk Link in 2012
 Two car manufacturers (e.g. Daimler & Chrysler)
 Two tour operators (e.g. TUI & First Choice)
 Asda buying Netto (food supermarkets)
 Amazon buying LoveFilm
 Virgin Money buying Northern Rock
The advantages of horizontal integration include the following:
1. It increases the size of the business and allows for more
internal economies of scale – lower long run average
costs – improved profits and competitiveness
2. One large firm may need fewer workers, managers and
premises than two – a process known as rationalization
again designed to achieve cost savings
3. Mergers often justified by the existence of “synergies”
Examples of Organic Growth
Poundland
Poundland was formed in 2000 and
has grown strongly due to a focus
on a constantly rotating product
range sold at a single price point.
Ten years after starting-up,
Poundland was sold to a US venture
capital firm for £200 million, when
its revenues had grown from
nothing to over £400m per year.
The organic strategies was to open
new stores in suitable locations and
repeat the formula of offering
heavily discounted products to a
mainly female customer base.
Poundland’s profits grow 26.5% in
the year to April 2012. It will open
60 new stores in 2012
BSkyB
In 2004, BSkyB set a long-term
objective of growing its household
subscriber base to 10 million
households/customers. The strategy
was to grow organically by focusing
on investment in content and
innovation.
2003: Revenue £3.2bn Profit £128m
2010: Revenue £5.9bn Profit
£1,173m
Subway
Subway is an American restaurant
franchise that mainly sells
submarine sandwiches (subs) and
salads. In 2001, Subway had just 52
franchised outlets in the UK, a tiny
number compared with its 14,800
around the world in 2001 As of
April, 2011, Subway operates
34,501 stores in 98 countries and
territories. There are currently
1,500 Subway franchises in the UK
and the company has recently
announced a new objective to grow
that to 3,000 outlets in the next
three years

9. © Tutor2u Limited 2013 9
Vertical Integration for a UK Chocolate
Retailer
Hotel Chocolat is a British cocoa grower and
chocolatier and undoubtedly one of the big
retail success stories in recent years. The
business has annual sales exceeding £70
million a study from Bain and Company
published in Marketing week recently placed
Hotel Chocolat as the 4th most consumer
advocated brand in the world, and the only
UK brand to appear in the top ten.
Hotel Chocolat is a vertically integrated
business that owns and operates cocoa
plantations in St Lucia (the Rabot Estate
pictured above) and which roasts and
manufactures chocolate in Cambridgeshire.
The business started with producing
peppermints for the corporate market and
Hotel Chocolat was one of the early adopters
of online e-retailing in the UK in the early
1990s. Digital channels have proved effective
throughout the growth story and sales from
the web site now account for around forty per
cent of the total.
4. Creates a wider range of products - (diversification). Opportunities for economies of scope
5. Reduces competition by removing rivals – increases market share and pricing power
Vertical integration:
Vertical Integration involves acquiring a business in the same
industry but at different stages of the supply chain. The
supply chain is the process by which production and
distribution gets products to the customer.
1. Forward vertical: Closer to the final consumers of
the product e.g. a manufacturer buying a retailer
2. Backward vertical: Closer to raw materials in the
supply chain e.g. a steel firm buying a coal mine
Examples of vertical integration might include the following:
 Film distributors owning cinemas and digital
streaming platforms
 Brewers owning/operating pubs (forward
vertical) or buying hop farms (backward
vertical)
 Crude oil exploration all the way through to
refined product sale
 Record labels and music stations
 Drinks manufacturers integrating with bottling
plants
 Hewlett Packard purchasing Autonomy, a UK
based software firm (Aug 2011)
 Google - a software business - buying
Motorola, a phone maker
 Publishing group Pearson paid more than
£500m for Grupo Multi - Brazil’s largest
private network of English language schools
(December 2013)
 Technology companies growing vertically through hardware, software and services
Examples of recent acquisitions in the technology space
Yahoo bought Tumblr for $1.1 bn in May 2013. This followed previous purchases such as Delicious, an
online-bookmarking service, and GeoCities, which hosts websites. Yahoo owns the photo-sharing site Flickr
Google bought YouTube, a video site, in 2006
Facebook acquired Instagram, a photo-sharing service in 2012
Amazon bought Goodreads, an online book-recommendation service
Twitter acquired UK’s Tweet Deck for $40m in 2011
Apple: In July 2013 Apple acquired Hop Stop, an app for helping people find their way across town using
public transport, and Locationary, which provides information about the locations of local businesses
Apple: in November 2013, Apple announced that it had acquired PrimeSense, Israeli tech business that
developed motion-detection software in gaming sensor Kinect
Google: in February 2014 - Google bought sound authentication firm SlickLogin

10. © Tutor2u Limited 2013 10
Advantages of Vertical Integration
The main advantages of vertical integration are:
1. Control of the supply chain – this helps to
reduce costs and improve the quality of
inputs into the production process
2. Improved access to key raw materials
perhaps at the expense of rival
businesses
3. Better control over retail distribution
channels e.g. pub companies who
ensure that their beers and wines are
sold in tenanted pubs and clubs
4. Removing suppliers, information from
competitors which helps to make a
market less contestable
Lateral / Conglomerate Integration
Lateral integration involves companies joining
together that produce similar but related
products. Examples include:
 Google and You Tube
 Proctor & Gamble acquiring Gillette in
2004
 Whitbread bought Coffee Nation vending
machines (March 2011)
 Microsoft’s takeover of Skype (May
2011)
 SSL International, the manufacturer of
Durex condoms was taken over by
healthcare conglomerate Reckitt
Benckiser (2010)
One of the main advantages of lateral integration
is to exploit economies of scope
Out-sourcing
Over a third of UK companies now do some of
their production work abroad, whilst 10% have
over half of their manufacturing offshore in lower cost locations. Dyson relocated production abroad to
Malaysia, whilst keeping their research and design operations in the UK.
There are several factors promoting outsourcing as a business strategy:
(1) Technological change – Information, communication and telecommunication costs are falling - this
makes it easier to outsource service and manufacturing operations to sub-contractors in other
countries. Technological advances now promote "Just in time delivery" inventory strategies for
the delivery of components and finished products and encourage the development of "virtual
manufacturing"
(2) Increased competition which increases the pressure on businesses to achieve lower costs as a
means of maintaining market share
Business acquisitions – the concept of synergy
Synergy can be defined as when the whole is greater
than the sum of the individual parts
In an acquisition synergy arises in two broad ways:
Many cost saving synergies arise from the greater
scale of the enlarged business. Two firms may be able
to use greater bargaining power to negotiate lower
prices from suppliers, or to demand better profit
margins from their distributors.
Acquisitions nearly always involve the removal or
downsizing of duplicated functions in the two
businesses. For example, if a publicly-quoted
company is taken over by another firm, there is no
need for both businesses to keep their full senior
management structure. There only needs to be one
Chairman, one CEO etc.
Revenue synergies (higher sales) are often harder to
identify and achieve - but they are an important part
of making an acquisition successful. After all, a
successful acquisition should mainly be about helping
a firm to grow more rapidly rather than simply taking
costs out of two businesses put together.

11. © Tutor2u Limited 2013 11
Cineworld and Picturehouse Takeover
In December 2012 a takeover worth £47
million was agreed between Cineworld and
Picturehouse cinema chains. Cineworld
operates 79 cinemas in the UK, the majority
of which are multiplex cinemas. As a result
of this deal Cineworld acquired an
additional 21 cinemas trading under the
Picturehouse brand. These cinemas are
smaller cinemas of between one - three
screens. Picturehouse advertises that the
focus of its film offering is targeted at art-
house and foreign language films.
Cineworld has identified the art-house
cinema sector as a growth opportunity and
has said that it plans to open a further 10
Picturehouse cinemas in locations around
the UK.
The UK’s cinema sector has been
consolidating for years. Three players –
Vue, Odeon & UCI, and Cineworld – now
control 70 per cent of the market between
them.
In April 2013, the Office of Fair Trading
(OFT) referred the completed acquisition by
Cineworld plc of City Screen Limited to the
Competition Commission (CC) after
concerns the merger reduces competition
and could restrict choice and increase
prices for cinema-goers.
The OFT identified that, in five local areas -
Aberdeen, Brighton, Bury St. Edmunds,
Cambridge and Southampton - the deal
raises a realistic prospect of a substantial
lessening of competition.
Source: Adapted from news reports
Joint Ventures between Businesses
 Joint ventures occur when businesses join together to
pursue a common project
 The businesses remain separate in legal terms
 Joint ventures are becoming common as firms want to
benefit from collaborative work in reaching a
mutually-agreed strategic target. An example might be
joint-research projects to share the fixed costs
Examples of joint ventures include:
 Vodafone & Telefónica agreed in 2012 to share more
of their mobile network (which contains more than
18,500 mobile mast sites). This was seen as a
response to Everything Everywhere - JV between T-
Mobile and Orange (current leader in the UK market)
 Vodafone also has a joint venture with Verizon
Wireless in the United States
 BMW and Toyota agreed a partnership in 2011 to co-
operate on hydrogen fuel cells, vehicle electrification,
lightweight materials and a future sports car.
Partnership agreements between competing
automakers are becoming increasingly common in the
industry as manufacturers seek to pool efforts on costly
technologies
 West Coast – a joint venture between Virgin Rail and
Stagecoach
 Google and NASA developing Google Earth
 Hollywood studios combining to fight internet piracy
 Renault-Nissan’s joint venture with Indian firm Bajaj to
produce a £1,276 car
 Intertrust Technologies, a JV between Sony and
Philips
 Alliances in the airline industry e.g. Star Alliance and
One World
 Burger King, the US fast food restaurant chain plans to
open 1,000 stores in China through a new joint venture
with a Turkish private equity business
 Starbucks agreeing a joint venture with Tata Beverages
to break into the Indian retail market
 Nokia Siemens Networks
 Joint Ventures between universities to deliver Massive
Open Online Courses (MOOCs) – a fast-expanding
sector of the higher education industry
 Every one of the world’s 24 biggest carmakers by
sales operates some form of alliance or joint venture
with another large carmaker.

12. © Tutor2u Limited 2013 12
Benefits and Costs of Acquisitions: Evaluation Comments on Mergers and Takeovers
Many takeovers and mergers fail to achieve their aims
1. Debt: Huge financial costs of funding takeovers including the burden of deals that have relied
heavily on loan finance
2. Share price: The need to raise fresh equity through a rights issue to fund a deal which can have a
negative impact on a company's share price. Over the three to five years after the deal on average,
the share price of the acquiring company tends to drop
3. Clash of cultures: Many mergers fail to enhance shareholder value because of clashes of
corporate cultures and a failure to find the all-important "synergy gains“ - Cultural incompatibility is
common in the case of cross-border acquisitions
4. Loss of human capital: The business may suffer a loss of personnel & customers post acquisition
5. Paying too much: With the benefit of hindsight we often see the ‘winners curse’ - i.e. companies
paying over the odds to take control of a business and ending up with little real gain in the medium
term. A good example would be the doomed takeover of ABM-AMRO by Royal Bank of Scotland
6. Job Losses: Integration often leads to sizeable job losses - Google, which acquired Motorola
Mobility (a manufacturer of mobile phones) for $12.5bn recently announced that it will make 20% of
Motorola’s workforce redundant
7. Bad timing – mergers and takeovers that take place towards the end of a sustained boom can often
turn out to be damaging for both businesses. A good example occurred in the UK property market
How takeovers and mergers fit into strategic choice
Innovation
Diversification
International Expansion
Cost leadership
Strategy Method
Organic / interna
Takeovers / m
Joint ventures or stra
Takeovers and mergers are rarely forced on a business - they are optional
If M&A is optional, then there must be some alternatives
E.g. could a joint venture or strategic alliance be as effective as a cross-border ta

13. © Tutor2u Limited 2013 13
with Taylor Woodrow's merger with Wimpey in a £5bn all-shares deal sealed just as property prices
were peaking. Since then house sales have collapsed due to the credit crunch and the merged
business has suffered huge losses

14. © Tutor2u Limited 2013 14
Competing in the Land of the Giants
The UK dairy processing industry is
dominated by a small group of huge milk
processing businesses including Mueller
Wiseman, Arla and Dairy Crest, the UK's
largest supplier.
However a cluster of privately owned
southwest dairy businesses have bucked the
trend of industry consolidation in milk
processing. Rodda’s, maker of the famous
Cornish clotted cream that embellishes the
strawberries at Wimbledon, grew sales by
third in 2012 to £29m. Yeo Valley Food, the
organic yoghurt and ice cream maker in
Blagdon in Somerset, now has sales of about
£200m. Wyke Farms in Bruton is a cheese
maker with sales of £75m.
These small to medium sized businesses
have found profitable segments of the
industry by producing niche and premium
priced products.
How can Smaller Businesses Survive and Thrive?
Over time there is a clear trend towards larger scale
businesses partly because of the pressures of competition; the
need to achieve economies of scale and the effects of
mergers and takeovers. However there are plenty of examples
where businesses are de-merging and divesting themselves
of some of their existing assets. And even in industries where
giant businesses dominate the market place, there is
frequently room for smaller firms to compete and survive
profitably.
1. Many smaller businesses act as a supplier / sub-
contractor to larger enterprises
2. They might take advantage of a low price elasticity
of demand and high income-elasticity of demand
for specialist ‘niche’ goods and services – these
products can be sold at a higher price and with a
bigger profit margin
3. Smaller businesses can avoid diseconomies of
scale associated with larger companies
4. Many smaller businesses are run as lifestyle
enterprises, their owners are looking to achieve a
satisfactory return rather than maximise profits
5. Small-scale businesses are often more innovative,
flexible and nimble in responding to changes in
market demand conditions.
Small Businesses in the British Economy
In the UK small and medium sized enterprises (SMEs) have been the engine of job creation for many years, and, indeed,
since the financial crisis. Employment in SMEs rose by 2.0% between 2008 and 2012 while large firms reduced their
headcount by 1.8%. Cost cutting and redundancies in large companies and the public sector have acted as a spur to
self-employment and business start-ups.
But surviving and expanding are tough for SMEs. The great majority of small businesses are sole traders or employ a
handful of people. Small firms tend to stay small and have a high mortality rate. In 2011, 261,000 firms employing fewer
than 100 people were formed in the UK - and 229,000 died. Most new jobs in SMEs come with the initial creation of the
business, not from subsequent growth. Despite a high mortality rate, the number of UK small firms has increased to
reach 4.8 million by 2012, a rise of 39% over 12 years. Over the same period the number of large businesses employing
more than 250 people fell by 19%. What is driving the growth in small businesses?
The expansion of services – the dominant sector in Western economies – has been a boon for entrepreneurs. In many
service industries capital costs are low, making it easier for small players to enter. Changing consumer tastes and rising
incomes have led to growing demand for customisation which favours nimble, niche players. Among those of working
age a desire for greater independence has helped boost the ranks of the self-employed. Advances in the internet,
computing and telecommunications have eroded some of the advantages of scale previously enjoyed by big business.
In reality, large and small companies are mutually dependent. The auto industry relies on networks of small companies
providing them with components. Small companies are a source of new ideas which, in sectors such as technology and
pharmaceuticals, are often exploited by large businesses. Small firms in turn benefit from knowledge ‘spill-overs’
generated by larger firms and rely upon larger suppliers for business and, at times, credit. Meanwhile, the high failure
rate of small businesses can be seen as a dynamic process, a necessary form of creative destruction which, in time,
allows a few winners – the Apples, Googles and Facebooks – to become behemoths.
Source: Ian Stewart, Deloitte Business Briefing, July 2013

15. © Tutor2u Limited 2013 15
Demergers and Divestment
 This is when a firm decides to split into separate firms
 A partial demerger means that the parent company retains a stake in the demerged business
 Demergers can also result from government intervention - for example BAA has been compelled by
the UK Competition Commission to sell off some airports in Britain including Gatwick & Stansted
 Some of the key motivations for de-merger include:
o Focusing on core businesses to streamline costs and improve profit margins
o Reduce the risk of diseconomies of scale and diseconomies of scope by reducing the
range of functions in a business, lower management costs
o Raise money from asset sales and return to shareholders
o A defensive tactic to avoid the attention of the competition authorities who might be
investigating possible monopoly power in an industry / market
Examples of recent demergers
Demergers are becoming increasingly common in many industries – here are ten examples:
1. The US pharmaceutical company Pfizer sold their infant nutrition business to Nestle and announced
a demerger of the animal health business (creating a new company called Zoetis)
2. Demerger of Cadbury's US drinks business creating a business called Dr Pepper Snapple Group
3. Severn Trent Water demerged its waste management business Biffa
4. Demerger of British Gas into a gas pipeline business Transco + an oil and gas exploration company
5. Talk Talk demerged from Carphone Warehouse in 2010
6. Fosters Group de-merging its two main operating divisions – one focusing on beer, the other on wine
7. Punch and Spirit pub groups created out of demerger of Punch Taverns in 2011. Punch Taverns had
seen a 95% fall in the share price of the business in the years leading up to the demerger. The
business had huge debts and selling off parts of the business was a way of cutting that debt.
8. US food giant Sara Lee sold off their coffee business Douwe Egberts
9. Quantas demerged their airline business and run stand-alone domestic and international airline
businesses with each having their own profit and loss account
10. News International announced plans in 2012 to demerge their Film and TV and Publishing
businesses. News International as a whole earned $25.3bn in revenue in 2012 with an operating
profit of $4.2bn. The business will be split into two.
FilmandTV
•Fox News
•20th Century Fox
•Sky
•Fox Television
Publishing
•Dow Jones
•Wall Street Journal
•New York Post
•The Times
•The Sun
•Harper Collins

16. © Tutor2u Limited 2013 16
3. Calculating the Revenue of a Firm
Revenue is the income generated from the sale of goods and services in a market
 Average Revenue (AR) = Price per unit = total revenue / output (the AR curve is the same as the
demand curve)
 Marginal Revenue (MR) = the change in revenue from selling one extra unit of output
 Total Revenue (TR) = Price per unit x quantity
The table below shows the demand for a product where there is a downward sloping demand curve.
Price per unit
(average revenue)
Quantity Demanded
(Qd)
Total Revenue
(TR) (PxQ)
Marginal Revenue
(MR)
£s units £s £s
340 460 156400
310 580 179800 195
280 700 196000 135
250 820 205000 75
220 940 206800 15
190 1060 201400 -45
Average and Marginal Revenue
 In the table above, as price per unit falls, demand expands and total revenue rises although because
average revenue falls as more units are sold, this causes marginal revenue to decline
 Eventually marginal revenue becomes negative, a further fall in price (e.g. from £220 to £190)
causes total revenue to fall.
The Relationship between Elasticity of Demand and Total Revenue
 When a firm faces a perfectly elastic demand curve, then average revenue = marginal revenue –
each unit sold add the same amount to total revenue
 However, most businesses face a downward sloping demand curve! And because the price per unit
must be cut to sell extra units, therefore MR lies below AR.
 MR curve will fall at twice the rate of the AR curve.
You don’t have to prove this for exams – the marginal revenue curve has twice the slope of the AR curve!
Maximum Revenue
 Maximum total revenue occurs where marginal revenue is zero: no more revenue can be achieved
from producing an extra unit of output
 This point is directly underneath the mid-point of a linear demand curve
 When marginal revenue is zero, the price elasticity of demand = 1
 When marginal revenue is zero, if prices were cut total revenue would fall, and if prices were raised
total revenue would fall
Total revenue when demand has low price elasticity
If price elasticity of demand < 1 (i.e. demand is inelastic), if prices are cut then demand rises by a smaller
proportion. Cutting price when demand is relatively inelastic means total revenue falls, or MR<0

17. © Tutor2u Limited 2013 17
Total revenue is shown by the area underneath the firm’s demand curve (average revenue curve).
A shift in the average revenue curve (AR) will also bring about a shift in the marginal revenue curve (MR)
Seasonal revenues: Many businesses experience seasonal fluctuations in revenues because the strength
of demand ebbs and flow at different times of the year. Good examples of seasonal shifts in demand and
revenues include beer producers, chocolate and card retailers, tourist attractions, online dating sites,
jewellers and perfumery businesses.
Output (Q)
Revenue
Total Revenue
(TR)
Marginal Revenue
(MR)
Average Revenue
(Demand) AR
Total revenue is
maximized when
MR = 0
Price elasticity of
demand = 1 at this
output
Ped >1 for a price
fall along this
length of AR
Costs
Output (Q)
Average revenue AR
Marginal revenue MRQ1
P1
Total revenue at price P1 where marginal
revenue is zero
A rise in price to P2 causes a reduction in total
revenue
P2
Q2
Total revenue at price P2

18. © Tutor2u Limited 2013 18
4. Calculating a Firm’s Costs
 In the short run, at least one factor of
production is fixed; this means that output can
be increased by adding more variable factors
such as employing more workers and buying in
more raw materials
Fixed costs
 Fixed costs do not change with output, firms
must pay these even if they shut down
 Examples include the rental costs of buildings;
the costs of leasing or purchasing capital
equipment; the annual business rate charged by
local authorities; the costs of employing full-time
contracted salaried staff; the costs of meeting
interest payments on loans; the depreciation of
fixed capital (due solely to age) and also the
costs of business insurance.
 Any business with significant capacity will
have high fixed costs, for example a vehicle
manufacturer that spends millions of pounds
building a new factory and installing expensive
and bulky capital equipment.
Fixed costs are the overhead costs of a business.
 Total fixed costs (TFC)
 Average fixed cost (AFC) = TFC / output
 Average fixed costs must fall continuously as
output increases because total fixed costs are
being spread over a higher level of production.
A change in fixed costs has no effect on marginal costs.
Marginal costs relate only to variable costs!
Variable Costs
 Variable costs vary directly with output –
when output is zero, variable costs will be zero
but as production increases, total variable costs
will rise
 Examples of variable costs include the costs of
raw materials and components, packaging and distribution costs, the wages of part-time staff or
employees paid by the hour, the costs of electricity and gas and the depreciation of capital inputs
due to wear and tear
Average variable cost (AVC) = total variable costs (TVC) /output (Q)
Total Cost (TC) = fixed costs + variable costs
Average Total Cost (ATC or AC)
 Average total cost is the cost per unit produced
 Average total cost (ATC) = total cost (TC) / output (Q)
Airline Costs – The Last Passenger is Key!
In 2012 the Wall Street Journal published an
investigation into the operating costs of
airlines in the United States. They started their
research with a simple question. On an
airplane carrying 100 passengers, how many
customers does it take, on average, to cover
the cost of the flight? The answer reveals
much about the low profit margins for many
airlines and emphasizes the need for airlines
to use pricing tactics to fill their planes and
generate as much extra revenue as possible.
On average it takes 99 paying passengers to
cover all costs and that only the 100th
passenger takes them into profit!
Some of the key costs for an airline are:
 Aviation fuel
 Salaries for airline staff
 Costs of buying and leasing planes
 Maintenance of assets including
planes
 Federal taxes
 Crash insurance
 Compensation paid for bumped
passengers or lost luggage
 In-flight catering costs
 Rental fees for gates & ticket
counters
 Landing fees
 Advertising and legal fees
Source: Wall Street Journal, June 2012

19. © Tutor2u Limited 2013 19
Marginal Cost
 Marginal cost is the change in total costs from
increasing output by one extra unit
 The marginal cost of supplying extra units of output is
linked with the marginal productivity of labour
 The law of diminishing returns implies that marginal
cost will eventually rise as output increases
 At some point, rising marginal cost will lead to a rise in
average total cost. This happens when the rise in AVC is
greater than the fall in AFC as output (Q) increases
Calculating Costs – A Numerical Example
A numerical example of short run costs is shown in the table
below. Fixed costs are assumed to be constant at £200. Variable costs increase as more output is produced.
Output (Q) Total Fixed Costs
(TFC)
Total Variable
Costs (TVC)
Total Cost Average Cost Per
Unit
Marginal Cost
(the change in
total cost from a
one unit change
in output)
(TC= TFC +
TVC)
(AC = TC/Q)
0 200 0 200
50 200 100 300 6 2
100 200 180 400 4 2
150 200 230 450 3 1
200 200 260 460 2.3 0.2
250 200 280 465 1.86 0.1
300 200 290 480 1.6 0.3
350 200 325 525 1.5 0.9
400 200 400 600 1.5 1.5
450 200 610 810 1.8 4.2
500 200 750 1050 2.1 4.8
 In our example, average cost per unit is minimised at a range of output - 350 and 400 units.
 Thereafter, because the marginal cost of production exceeds the previous average, so average cost
rises (for example the marginal cost of each extra unit between 450 and 500 is 4.8 and this increase
in output has the effect of raising the cost per unit from 1.8 to 2.1).
An example of fixed and variable costs in equation format
If for example, the short-run total costs of a firm are given by the formula
SRTC = $(10 000 + 5X2
) where X is the level of output.
 The firm’s total fixed costs are $10,000
 The firm’s average fixed costs are $10,000 / X
 If the level of output produced is 50 units, total costs will be $10,000 + $2,500 = $12,500
Marginal costs of farming
Farmers in the United States are
facing higher marginal costs for
each area of their land cultivated.
According to North Dakota State
University, the cost per acre in the
state for wheat has surged from
$2.89 in 2004 to $5.03 in 2011 due
to more expensive seeds,
fertilizers, fuel and labour.

20. © Tutor2u Limited 2013 20
Short Run Cost Curves
 In the diagram below, when diminishing returns set in (beyond output Q1) marginal cost rises
 Average cost per unit falls until output Q2 where the rise in average variable cost (AVC) equates
with the fall in average fixed cost (AFC)
 Output Q2 is the lowest point of the ATC curve. This is the output of productive efficiency
 The marginal cost curve (MC) will cut both the average variable cost curve (AVC) and average total
cost curve (ATC) at their minimum point
Costs
Output (Q)
Average Fixed
Cost (AFC)
Average
Variable Cost
(AVC)
Average Total
Cost (ATC)
Marginal Cost
(MC)
Q1 Q2

21. © Tutor2u Limited 2013 21
The Effects of an Increase in Variable Costs
 A rise in variable costs of production – perhaps due to a rise in oil and gas prices or a rise in the
national minimum wage - leads to an upward shift both in marginal and average total cost
 The firm is not able to supply as much output at the same price
 The effect is that of an inward shift in the supply curve of a business in a competitive market
Showing Changes in Fixed Costs
 An increase in fixed costs has no effect on the variable costs of production
 This means that only the average total cost curve shifts
 There is no change on the marginal cost + no change in the profit maximising price and output
 The effects of an increase in the fixed costs of a business are shown in the next diagram
Costs
Output (Q)
Average
Variable Cost
(AVC1)
Average Total
Cost (ATC1)
Marginal Cost
(MC1)
MC2 AC2
AVC2
Costs
Output (Q)
AC1
MC
AC2 (after rise
in fixed costs)

22. © Tutor2u Limited 2013 22
Rising costs for household goods giant Unilever
Unilever - the world’s second-biggest consumer-goods company – has announced that profitability might fall even after it
increased prices to offset soaring costs for the commodities used to make its products. Unilever, the manufacturer of
numerous household-name brands including Dove soap, Bertolli sauces, Coleman’s mustard, Vaseline, Lynx deodorant,
Knorr soup, Lipton tea, Magnum ice cream and Domestos bleach has been affected by a sharp rise in the prices of
ingredients, oil and packaging. It has chosen to pass on some of the rise in costs to its main customers - supermarkets
and grocery stores around the world.
In response the CEO of Unilever has attempt to streamlining packaging, paring logistics, sourcing and purchasing costs.
A cut in overheads will also help to maintain profitability. All food companies are grappling with higher costs, Unilever is
in direct competition with Proctor and Gamble, Danone and Nestle. They all have significant buying power - for example,
Unilever each year buys up to 12% of the world’s black tea crop and 6% of its tomatoes. It is one of the world’s largest
buyers of palm oil, which it uses in margarine and skincare products. The world price of palm oil has risen as much as 40
percent in the last year.
Cost curves for businesses with fixed costs only
The diagram below shows the cost and revenue curves of a monopoly producer who’s only cost of
production is a fixed cost.
If the marginal cost of production is zero, then total cost will stay the same as output increases. The result is
that the average fixed cost curve is the same as the average total cost curve and will fall continuously as
production expands.
Costs
Output (Q)
Average
Fixed Cost
= Average
Total Cost

23. © Tutor2u Limited 2013 23
Case Study: The Cost and Market Price of Gas
High gas prices impact on millions of households whose energy bills have soared in recent years and have
led to a steep increase in fuel poverty among lower-income families. A standard gas bill for UK consumers
getting their suppliers from Centrica – owned by British Gas - breaks down as follows:
 56% - cost of gas bought from the wholesale market
 21% - cost of delivering gas to the home – including the cost of building, maintaining and operating
the local gas pipes
 10% - cost of obligations imposed by government such as environmental taxes plus VAT at 5%
 8% - other operating costs of British Gas – including the costs of building, maintaining and operating
the high pressure gas transmission networks
 5% - profit for gas suppliers
The average credit gas bill for a typical consumer was £836 in 2012. This was more than double the 2001
low in real terms. In 2012, Centrica earned a profit of £48 on the average UK residential dual-fuel bill of
£1,188
The UK gas supply industry is an oligopoly dominated by British Gas, EDF, E.ON, Npower, Scottish Power,
and Scottish & Southern.
The industry watchdog Consumer Focus estimates that 6.5m UK households spend more than ten per cent
of their household income on energy bills, which is defined as being in fuel poverty. Gas companies have
been heavily criticised for being quick to raise their prices when gas prices on the wholesale market head
higher, but delay price reductions when world prices dip.

24. © Tutor2u Limited 2013 24
5. Production in the
Short and the Long
Run
Production Functions
The production function relates the quantity of
factor inputs used by a business to the amount
of output that result. We use three measures of
production and productivity:
o Total product (or total output). In
manufacturing industries such as motor
vehicles and DVD players, it is
straightforward to measure how much
output is being produced. In service or
knowledge industries, where output is less “tangible” it is harder to measure productivity.
o Average product measures output per-worker-employed or output-per-unit of capital.
o Marginal product is the change in output from increasing the number of workers used by one
person, or by adding one more machine to the production process in the short run.
The length of time required for the long run varies from sector to sector. In the nuclear power industry for example, it can
take many years to commission new nuclear power plant and capacity. This is something the UK government has to
consider as it reviews our future sources of energy.
Short Run Production Function
 The short run is a time period where at least one factor of production is in fixed supply
 A business has chosen it’s scale of production and must stick with this in the short run
 We assume that the quantity of plant and machinery is fixed and that production can be altered by
changing variable inputs such as labour, raw materials and energy
Diminishing Returns
 In the short run, the law of diminishing returns states that as more units of a variable input are
added to fixed amounts of land and capital, the change in total output will first rise and then fall
 Diminishing returns to labour occurs when marginal product of labour starts to fall. This means
that total output will be increasing at a decreasing rate
What might cause marginal product to fall? One explanation is that, beyond a certain point, new workers will
not have as much capital equipment to work with so it becomes diluted among a larger workforce.
In the following numerical example, we assume that there is a fixed supply of capital (20 units) to which
extra units of labour are added.
 Initially, marginal product is rising – e.g. the 4th
worker adds 26 to output and the 5th
worker adds 28
and the 6th
worker increases output by 29.
 Marginal product then starts to fall. The 7th
worker supplies 26 units and the 8th
worker just 20 added
units. At this point production demonstrates diminishing returns.
 Total output will continue to rise as long as marginal product is positive
 Average product will rise if marginal product > average product

25. © Tutor2u Limited 2013 25
The Law of Diminishing Returns
Capital Input Labour Input Total Output Marginal Product Average Product of Labour
20 1 5 5
20 2 16 11 8
20 3 30 14 10
20 4 56 26 14
20 5 85 28 17
20 6 114 29 19
20 7 140 26 20
20 8 160 20 20
20 9 171 11 19
20 10 180 9 18
Diagram to show diminishing returns as extra labour is employed
Average product rises as long as marginal product is greater than the average – e.g. when the seventh
worker is added the marginal gain in output is 26 and this drags the average up from 19 to 20 units. Once
marginal product is below the average as it is with the ninth worker employed then the average must decline.
Criticisms of the Law of Diminishing Returns
 How realistic is this assumption of diminishing returns? Surely ambitious and successful businesses
will do their level best to avoid such a problem emerging?
 It is now widely recognised that the effects of globalisation and the ability of trans-national
businesses to source their inputs from more than one country and engage in transfers of business
technology, makes diminishing returns less relevant as a concept.
 Many businesses are multi-plant meaning that they operate factories in different locations – they
can switch output to meet changing demand.
Total
Output
(Q)
Units of Labour Employed (L)
(Q)Slope of the curve gives the
marginal product of labour
Diminishing returns are apparent
here – total output is rising but at a
decreasing rate

26. © Tutor2u Limited 2013 26
Long Run Production - Returns to Scale
In the long run, all factors of production are variable. How the output of a business responds to a change
in factor inputs is called returns to scale.
Numerical example of long run returns to scale
Units of
Capital
Units of
Labour
Total
Output
% Change in
Inputs
% Change in
Output
Returns to Scale
20 150 3000
40 300 7500 100 150 Increasing
60 450 12000 50 60 Increasing
80 600 16000 33 33 Constant
100 750 18000 25 13 Decreasing
 When we double the factor inputs from (150L + 20K) to (300L +
40K) the % change in output is 150% - increasing returns
 When the scale of production is changed from (600L + 80K0 to
(750L + 100K) then the percentage change in output (13%) is
less than the change in inputs (25%) i.e. decreasing returns
 Increasing returns to scale occur when the % change in output
> % change in inputs
 Decreasing returns to scale occur when the % change in
output < % change in inputs
 Constant returns to scale occur when the % change in output
= % change in inputs
The nature of the returns to scale affects the shape of a business’s long run average cost curve
Finding an optimal mix between labour and capital
In the long run businesses will be looking to find an
output that combines labour and capital in a way that
maximises productivity and reduces unit costs
towards their lowest level.
This may involve a process of capital-labour
substitution where capital machinery and new
technology replaces some of the labour input.
In many industries over the years we have seen a
rise in the capital intensity of production - good
examples include farming, banking and retailing.
Robotic technology is extensively used in many
manufacturing / assembly industries such as cars
and semi-conductors. The image on the left is of a
Ford car assembly factory in India.

27. © Tutor2u Limited 2013 27
6. Long Run Costs: Economies of Scale
A huge distribution centre operated by Sainsburys – with lots of different economies of scale in action!
Economies of Scale
 In the long run all costs are variable and the scale of production can change (no fixed inputs)
 Economies of scale are the cost advantages from expanding the scale of production in the long
run. The effect is to reduce average costs over a range of output.
 These lower costs represent an improvement in productive efficiency and can give a business a
competitive advantage in a market. They lead to lower prices and higher profits – this is called a
positive sum game for producers and consumers (i.e. the welfare of both will improve)
 We make no distinction between fixed and variable costs in the long run because all factors of
production can be varied.
 As long as the long run average total cost curve (LRAC) is declining, then internal economies of
scale are being exploited. The table below shows a numerical example of falling LRAC
Long Run Output (Units) Total Costs (£s) Long Run Average Cost (£ per unit)
1000 12000 12
2000 20000 10
5000 45000 9
10000 80000 8
20000 144000 7.2
50000 330000 6.6
100000 640000 6.4
500000 3000000 6

28. © Tutor2u Limited 2013 28
Returns to Scale and Costs in the Long Run
The table below shows how changes in the scale of production can, if increasing returns to scale are
exploited, lead to lower average costs.
Factor Inputs Production Costs
(K) (La) (L) (Q) (TC) (TC/Q)
Capital Land Labour Output Total Cost Average
Cost
Scale A 5 3 4 100 3256 32.6
Scale B 10 6 8 300 6512 21.7
Scale C 15 9 12 500 9768 19.5
Costs: Assume the cost of each unit of capital = £600, Land = £80 and Labour = £200
Because the % change in output exceeds the % change in factor inputs used, then, although total costs rise,
the average cost per unit falls as the business expands from scale A to B to C
Examples of Increasing Returns to Scale
Much of the new thinking in economics focuses on the increasing returns available to growing businesses:
An example of this is the software business.
1. The overhead costs of developing new software programs or computer games are huge - often
running into hundreds of millions of dollars
2. The marginal cost of one extra copy for sale is close to zero, perhaps just a few cents or pennies.
3. If a company can establish itself in the market, positive feedback from consumers will expand the
installed customer base, raise demand and encourage the firm to increase production.
4. Because marginal cost is low, the extra output reduces average costs creating economies of size.
Capacity Utilisation, Fixed Costs and Profits
 Lower costs normally mean higher profits and increasing financial returns for the shareholders.
What is true for software developers is also important for telecoms companies, transport operators
and music distributors.
 We find across many different markets that, when a high percentage of costs are fixed the higher the
level of production the lower will be the average cost of production. Strong demand means that
capacity utilization rates are high and this lowers the unit cost of supply.
Long Run Average Cost Curve
 The long run average cost curve (LRAC) is known as the ‘envelope curve’ and is usually drawn on
the assumption of their being an infinite number of plant sizes – hence its smooth appearance in the
next diagram below.
 The points of tangency between LRAC and SRAC curves do not occur at the minimum points of
the SRAC curves except at the point where the minimum efficient scale (MES) is achieved.
 If LRAC is falling when output is increasing then the firm is experiencing economies of scale. For
example a doubling of factor inputs might lead to a more than doubling of output.
 Conversely, When LRAC eventually starts to rise then the firm experiences diseconomies of scale,
and, If LRAC is constant, then the firm is experiencing constant returns to scale
 The working assumption is that a business will choose the least-cost method of production in the
long run. Moving down the LRAC means there are cost advantages from a bigger scale of
operations.

29. © Tutor2u Limited 2013 29
What are the main Examples of Internal Economies of Scale? (IEoS)
Internal economies of scale come from the long-term growth of the firm. Examples include:
1. Technical economies of scale:
These refer to gains in productivity from scaling up production.
a. Expensive (indivisible) capital inputs: Large-scale businesses can afford to invest in
specialist capital machinery. For example, a supermarket might invest in database
technology that improves stock control and reduces transportation and distribution costs.
b. Specialization of the workforce: Larger firms can split the production processes into
separate tasks to boost productivity. Examples include the use of division of labour in the
mass production of motor vehicles and in manufacturing electronic products.
c. The law of increased dimensions (also known as the “container principle”) This is linked
to the cubic law where doubling the height and width of a tanker or building leads to a more
than proportionate increase in the cubic capacity
i. The application of this law opens up the possibility of scale economies in distribution
and freight industries and also in travel and leisure sectors with the emergence of
super-cruisers such as P&O’s Ventura. Consider the new generation of super-
tankers and the development of enormous passenger aircraft such as the Airbus
280 which is capable of carrying over 500 passengers on long haul flights.
ii. The law of increased dimensions is also important in the energy sectors and in
industries such as office rental and warehousing. Amazon for example has invested
in several huge warehouses at its central distribution points – capable of storing
hundreds of thousands of items.
d. Learning by doing: The average costs of production decline in real terms as a result of
production experience as businesses cut waste and find the most productive means of
producing output on a bigger scale. Evidence across a wide range of industries into so-
called “progress ratios”, or “experience curves”, indicate that unit manufacturing costs
typically fall by between 70% and 90% with each doubling of cumulative output.
LRAC
SRAC1
SRAC2 SRAC3
Costs
AC3
The Long Run Average Cost Curve (LRAC)
AC1
AC2
Q2 Q3 Output (Q)Q1

30. © Tutor2u Limited 2013 30
2. Marketing Economies - Monopsony Power:
a. A large firm can purchase its factor inputs in bulk at discounted prices if it has
monopsony (buying) power. A good example would be the ability of the electricity
generators to negotiate lower prices when finalizing coal and gas supply contracts
b. Large food retailers have monopsony power when purchasing their supplies from farmers
and wine growers and in completing supply contracts from food processing businesses.
Other controversial examples of the use of monopsony power include the prices paid by
coffee roasters and other middlemen to coffee producers in some of the poorest countries
3. Managerial economies of scale: This is a form of division of labour where firms can employ
specialists to supervise production systems. Better management; increased investment in human
resources and the use of specialist equipment, such as networked computers can improve
communication, raise productivity and thereby reduce unit costs.
4. Financial economies of scale: Larger firms are usually rated by the financial markets to be more
‘credit worthy’ and have access to credit with favourable rates of borrowing. In contrast, smaller
firms often pay higher rates of interest on overdrafts and loans. Businesses quoted on the stock
market can normally raise new financial capital more cheaply through the sale of equities to the
capital market. The credit crunch and fragility of the banking system has made raising finance harder
for businesses of all sizes – bank overdraft and loan interest rates have increased across the board,
but it remains true that larger corporations can still access credit at a cheaper cost.
5. Network economies of scale: There is growing interest in the concept of a network economy.
Some networks and services have huge potential for economies of scale. That is, as they are more
widely used (or adopted), they become more valuable to the business that provides them.
Case Study: Small businesses and financial economies of scale
A Bank of England survey on financial and credit conditions finds that smaller businesses are finding it tough to get the
credit they need to finance an upturn in sales and production.
Interest rate spreads on new loans are rising and it is larger firms that seem to be benefitting from lower borrowing costs.
According to the report “larger businesses are enjoying a reduction in the cost of borrowing and improved access to
credit as banks favour lower-risk custom.”
The main commercial banks continue to adopt a risk-averse approach to new lending and this may hamper prospects of
recovery. Unsecured loans for consumers have also become harder to get and more expensive despite the ultra-low
interest rate policy of the Bank of England. In 2006, the top 10 average rate for a £3,000 personal loan was 6.49%, but
today it is 14.92%, analysis by price comparison website moneysupermarket.com has shown.
Source: Tutor2u economics blog, April 2010

31. © Tutor2u Limited 2013 31
What are Network Economies of Scale?
The power of networks is becoming increasingly recognized in the
economics of long run costs, revenues and profits.
Many networks have huge potential for economies of scale. That is, as
they are more widely used (or adopted), they become more valuable to
the business that provides them.
Good examples to use include online auction sites such as eBay, social
networking sites, wireless service providers, air and rail transport
networks and businesses such as Amazon.
In most cases, the marginal cost of adding one more user or customer to a network is close to zero, but the resulting
financial benefits may be huge because each new user to the network can then interact, trade with all of the existing
members or parts of the network.
Given the high fixed costs of establishing a network, the more users there are the lower are the fixed costs per unit.
Thus as the network expands, not only are there potential gains from extra revenues, but the long run cost per user
diminishes - an internal economy of scale.
In some cases an industry that requires a network to fulfill customer needs and wants across a country or region might
be classified as a natural monopoly - an industry where long run average cost falls over a huge range of output and
where the minimum efficient scale is a large percentage of market demand.
Consider as examples the networks required by the major utilities such as water, gas, electricity and (fixed line)
broadband suppliers. And perhaps businesses such as Network Rail and the Royal Mail might also claim to have aspects
of a natural monopoly given the requirement for the former to maintain and improve a national rail infrastructure and, for
the latter, to keep a universal postal service running to add postal addresses in the country - this is of course a loss-
making aspect of their business model.
Where there are strong grounds for believing an industry is a natural monopoly, there might be a case for nationalizing
and/or regulating the network element of the business but introducing competition into the actual service provision - e.g.
franchise bids for train operating companies, and partial or complete deregulation of parcel and letter collection, sorting
and delivery.
Source: Tutor2u Economics Blog

32. © Tutor2u Limited 2013 32
Analysis: Economies of Scale – The Effects on Price, Output and Profits
 Consider the diagram below - scale economies allow a supplier to move from SRAC1 to SRAC2
 A profit maximizing producer will produce at a higher output (Q2) and charge a lower price (P2) as a
result – but the total profit is also much higher (compare the two shaded regions)
 Both consumer and producer surplus has increased – there has been an improvement in economic
welfare and efficiency – the key is whether these cost savings are passed onto consumers!
Analysis Diagram for External Economies of Scale (EEoS)
The diagram below shows the effects of external economies of scale that benefit the majority of businesses
that operate in a given industry.
Costs
Output (Q)
SRAC1
SRAC2
AR
(Demand)
MR
MC1
MC2
P1
P2
Q1 Q2
Profit at Price P1
Profit at Price P2
Cost
(Per unit of output)
LRAC1
B
Economies of Scale
LRAC2
External
Economies of
Scale
C
A
Output

33. © Tutor2u Limited 2013 33
 External economies of scale occur outside of a firm but within an industry.
 For example investment in a better transport network servicing an industry will resulting in a
decrease in costs for a company working within that industry
 Investment in industry-related infrastructure including telecommunications can cut costs for all
 Another example is the development of research and development facilities in local universities
that several businesses in an area can benefit from
 Likewise, the relocation of component suppliers and other support businesses close to the centre
of manufacturing are also an external cost saving
 Agglomeration economies may also result from the clustering of businesses in a distinct
geographical location e.g. software in Silicon Valley or investment banks in the City of London
Case Studies in External Economies of Scale
Formula One
Britain has a history of providing a base for some of the most
successful teams in Formula One. McLaren are based in Woking
but Renault, Honda, Williams and Red Bull are all clustered in the
east Midlands. Partly this is an accident of history - namely the
availability of disused airfields after the war.
But the cluster of F1 teams is also a good example of the external
economies of scale that can be generated when a group of
producers develop and expand in a relatively small geographical
area.
Most of the teams currently racing are based in the UK, along with
their R&D operations. A whole network of industries, such as
component suppliers, engineering and design firms, have sprung
up in Britain, mostly in central England, to serve the sport both here and abroad. F1 also helps to support a
far larger motorsport industry in the UK, for example rally car racing and all its associated industries.
Estimates of the total number of jobs dependent on motorsport in the UK vary between 45,000 and 110,000.
Geoff Goddard, professor in Motorsport Engineering Design at Oxford Brookes University, estimates that it
accounts for 1 per cent of GDP, not insignificant when compared to car manufacturers, which represent
about 5 per cent.
Science Cities
Science cities are knowledge clusters that bring together higher education expertise and entrepreneurial
zeal. Their number continues to grow
from California and Boston in the
USA, Cambridge in the UK,
Education City in Qatar, Science City
in Zurich and Digital Media City in
Seoul.
In London there is much excitement
about Tech City, an area around
Shoreditch and Old Street in east
London which is home to a growing
number of technology digital and
creative companies. It is also known
as Silicon Roundabout and recent
estimates suggest there are 3,200
firms in the area employing some 48,000 people
Source: Tutor2u Economics Blog

34. © Tutor2u Limited 2013 34
Economies of Scale – The Importance of Market Demand
 The market structure of an industry is affected by the
extent of economies of scale available to individual
suppliers and by the total size of market demand.
 In many industries, it is possible for smaller firms to make
a profit because the cost disadvantages they face are
relatively small. Or because product differentiation
allows a business to charge a price premium to
consumers which more than covers their higher costs.
 A good example is the retail market for furniture. The
industry has major players in different segments (e.g. flat-
pack and designer furniture) including the Swedish giant
IKEA. However, much of the market is taken by smaller-
scale suppliers with consumers willing to pay higher prices
for bespoke furniture owing to the low price elasticity of
demand for high-quality, hand crafted furniture products.
 Small-scale manufacturers can extract the consumer
surplus that is present when demand is estimated to have
a low elasticity of demand.
Economies of Scope
 Economies of scope occur where it is cheaper to
produce a range of products rather than specialize in just
a handful of products.
For example, in the competitive world of postal services and
business logistics, service providers such as Royal Mail, UK Mail,
Deutsche Post and parcel carriers including TNT, UPS, and FedEx
are broadening the range of their services and making better use
of their collection, sorting and distribution networks to reduce costs
and earn higher profits from higher-profit-margin and fast growing
markets.
 A company’s management structure, administration
systems and marketing departments are capable of
carrying out these functions for more than one product.
 Expanding the product range to exploit the value of
existing brands is a way of exploiting economies of scope.
 A good example of “brand extension” is the Easy Group
under the control of Stelios where the distinctive Easy
Group business model has been applied (with varying
degrees of success) to a wide range of markets – easy
Pizza, easy Cinema, easy Car rental, easy Bus and easy
Hotel to name just a handful!
 Procter and Gamble is the largest consumer household
products maker in the world. Its brands include Crest,
Duracell, Gillette, Pantene, and Tide, to name just a few.
Twenty four of its brands make over $1 billion in sales
annually.
Another example of an economy of scope might be a restaurant
that has catering facilities and uses it for multiple occasions – as a
coffee shop during the day and as a supper-bar and jazz room in
the evenings. A computing business can use its network and
databases for many different uses.
Has global outsourcing peaked?
Outsourcing involves passing work to
a subcontractor who takes on that
role. Over the past few decades
companies have contracted out
everything from mopping the floors to
spotting the flaws in their internet
security. One estimate is that $100
billion-worth of new contracts are
signed every year. In Britain, 10% of
workers toil away in “outsourced” jobs
and companies spend $200 billion a
year on outsourcing.
But is it as useful as its fans claim?
There are signs that outsourcing often
goes wrong, and that companies are
rethinking their approach to it. Recent
figures suggest that the value of
outsourcing contracts is falling
steeply.
Some of the worst business disasters of
recent years have been caused or
aggravated by outsourcing. Eight
years ago Boeing, America’s biggest
aero plane-maker, decided to hire
contractors to do most of the grunt
work on its new 787 Dreamliner. The
result was a nightmare. Some of the
parts did not fit together. Some of the
dozens of sub-contractors failed to
deliver their components on time,
despite having sub-contracted their
work to sub-sub-contractors.
Sometimes companies squeeze their
contractors so hard that they are
forced to cut corners. Vendors may
overpromise in order to win a contract
and then fail to deliver. And service
companies, contract out customer
complaints to foreign call centres and
then wonder why their customers hate
them.
When outsourcing goes wrong, it is
hard to put right.

35. © Tutor2u Limited 2013 35
Key global trends affecting business
strategies
A new report by consultants Ernst & Young
examines six broad, long-term developments
which shape business around the globe. In
summary, the six trends are:
(1) Emerging markets increase their global
power
(2) Cleantech becomes a competitive
advantage
(3) Global banking seeks recovery through
transformation
(4) Governments enhance ties with the private
sector
(5) Rapid technology innovation creates a
smart, mobile world
(6) Demographic shifts transform the global
workforce
The Importance of Minimum Efficient Scale (MES)
 The minimum efficient scale (MES) is the scale of output where the internal economies of scale
have been fully exploited.
 MES corresponds to the lowest point on the long run average cost curve and is also known as
an output range over which a business achieves productive efficiency.
 MES is not a single output level – more likely, the MES is a range of outputs where the firm
achieves constant returns to scale and has reached the lowest feasible cost per unit.
The minimum efficient scale depends on the nature of costs of production in a specific industry.
1. How many firms can "fit" in a market? It depends on the size of the market compared to the size of
the minimum efficient scale
2. In industries where the ratio of fixed to variable costs is high, there is scope for reducing unit cost
by increasing the scale of output. This is likely to result in a concentrated market structure (e.g. an
oligopoly, a duopoly or a monopoly) – indeed
economies of scale may act as a barrier to
entry because existing firms have achieved
cost advantages and they then can force
prices down in the event of new businesses
coming in
3. There might be only limited opportunities for
scale economies such that the MES turns out
to be a small % of market demand. It is likely
that the market will be competitive with
many suppliers able to achieve the MES. An
example might be a large number of hotels in
a city centre or a cluster of restaurants in a
town. Much depends on how we define the
market!
4. With a natural monopoly, the long run
average cost curve continues to fall over a
huge range of output, suggesting that there
may be room for perhaps one or two
suppliers to fully exploit all of the available
economies of scale when meeting market
demand.
Costs
Revenues
Output (Q)MES
LRAC
Increasing return to scale –
economies of scale - falling LRAC
Decreasing returns –
diseconomies of scale

36. © Tutor2u Limited 2013 36

37. © Tutor2u Limited 2013 37
7. Diseconomies of Scale
Diseconomies are the result of decreasing returns to scale and
lead to a rise in average cost
Diseconomies of scale in a large business may be due to:
1. Control – monitoring the productivity and the quality of
output from thousands of employees in big, complex
corporations is imperfect and expensive – this links to
the concept of the principal-agent problem i.e. the
difficulties of shareholders monitoring the performance of
managers.
2. Co-ordination - it can be difficult to co-ordinate
complicated production processes across several plants
in different locations and countries. Achieving efficient
flows of information in large businesses is expensive
as is the cost of managing supply contracts with
hundreds of suppliers at different points of an industry’s
supply chain.
3. Co-operation - workers in large firms may develop a
sense of alienation and loss of morale. If they do not
consider themselves to be an integral part of the
business, their productivity may fall leading to wastage of
factor inputs and higher costs
Big organizations often suffer from the debilitating effects of
internal politics, information over-load, complex bureaucracy,
unrealistic expectations among managers and cultural clashes
between senior people with inflated egos. The result can be that
hidden costs increase quickly – expense accounts, a slump in
productivity, a deadweight loss of time in slow-moving big
businesses. This is the essence of diseconomies of scale.
Avoiding diseconomies of scale
1. Human resource management (HRM) focuses on
improvements in recruitment, communication, training,
promotion, retention and support of faculty and staff. This
becomes critical to a business when the skilled workers it
needs are in short supply.
2. Performance related pay schemes (PRP) can provide
financial incentives for the workforce leading to an
improvement in industrial relations and higher
productivity. The John Lewis Partnership is often cited as
an example of how a business can empower its
employees by giving them a stake in the financial
success of the organization. Each partner gets a share of
the firm’s profits each year,
3. Out-sourcing is a tried and tested way of reducing costs
whilst retaining control over production although there
may be a price to pay in terms of the impact on the job
security of workers whose functions might be outsourced
overseas.
Fundamentally the best way to avoid diseconomies of scale is to
make business organization less complex and more transparent.
Nokia, diseconomies of scale and lost
competitive advantage
Nokia is a Finnish conglomerate business
that turned itself into the world’s leading
mobile phone company in the 1990s.
Nokia is profitable, but revenues are
under pressure and in 2010, Nokia
appointed a new CEO - Stephen Elop - to
drive strategic change
In February 2011 - Elop issued the famous
“burning platform” memo bluntly
explaining the strategic challenges facing
Nokia. Elop announced a strategic
partnership with Microsoft to jointly-
develop smart phones using the Windows
mobile platform - ditching Nokia’s
investment in its homegrown Symbian
platform
Nokia had missed the major change in its
market - the Smartphone revolution. It
had continued to focus on mobile phone
devices (hardware) rather than
applications (software). The consumer
transition from traditional mobile phones
to smart phones has been dramatic and
caught Nokia off-guard. According to Elop
"There is intense heat coming from our
competitors, more rapidly than we ever
expected. Apple disrupted the market by
redefining the Smartphone and attracting
developers to a closed, but powerful
ecosystem.”
Nokia has also faced intense competition
from mobile phone producers in emerging
markets who can make fast, cheap
handset. At the same time there was
recognition within the business that
diseconomies of scale were hurting its
competitiveness. Many in Nokia regretted
that the business had become too
product-led rather than customer-led. It
was felt that the business lacked
innovation with an overly-bureaucratic
organisational structure with poor
accountability.

38. © Tutor2u Limited 2013 38
Case Study: Amazon – Economies of Scale and Scope and Market Power
1. Increased dimensions: Firstly, the company invested in enormous warehouses to stock its
inventory of books, DVDs, computer peripherals. This allows it to benefit from the law of increased
dimension.
2. Buying power: Amazon has significant monopsony power when it purchases books directly from
publishers, thereby bypassing its reliance on wholesalers and giving it a higher profit margin.
3. Learning by doing and first-mover advantage: The unit costs of production tend to decline in real
terms as a result of production experience as businesses cut waste and find the most productive
means of producing output on a bigger scale
4. Pre-Orders - Amazon use a pre-order system for customers that allows it to capture early demand
and improve stock (or inventory) forecasting.
5. Less invested capital: As an online retailer, Amazon avoids the need for retail stores – one
advantage is that it has lower invested capital in the business and it frees up resources for customer
fulfillment and investment in new technology – Amazon distributes to over 200 countries.
6. Shifting stock at speed: Amazon has a much faster stock velocity – measured by the number of
weeks an item remains in stock. For Amazon this is half that of a physical store – and the benefit is a
reduction in obsolescence loss (the value of unsold stock is estimated to decline by 30% per year)
Economies of scale help to give Amazon a significant cost advantage. The business is also looking to
create economies of scope from marketing and broadening the range of products available through the
Amazon brand. Among the innovative business ideas under development we can identify:
 Merchants@/Marketplace which gives independent (third party) sellers the opportunity to sell their
products through the Amazon platform
 Amazon Enterprise Solutions – where Amazon provides e-commerce technology for a range of
partners such as Marks and Spencer, Lacoste, Mothercare and Timex
 Amazon Kindle – a portable reader that wirelessly downloads books, blogs, magazines and
newspapers to a high-resolution electronic paper display that looks and reads like real paper,
Amazon now sells nearly one fifth of the books bought in the UK each year.

39. © Tutor2u Limited 2013 39
8. Profits
The Nature of Profit
 Profit measures the return to risk when committing
scarce resources to a market or industry
 Entrepreneurs organise factors of production and take
risks for which they require an adequate rate of return.
 The higher the market risk and the longer they expect to
have to wait to earn a positive return, the greater will be
the minimum required return that an entrepreneur is
likely to demand
 Economists distinguish between different types of profit:
Normal profit
 Normal profit is the minimum profit required to keep
factors of production in their current use in the long run.
 Normal profits reflect the opportunity cost of using
funds to finance a business. If you put £200,000 of
savings into a new business, those funds could have
earned a low-risk rate of return by being saved in a bank
account. You might use the rate of interest on that
£200,000 as the minimum rate of return that you need to
make from your investment
 Because we treat normal profit as an opportunity cost
of investing financial capital in a business, we include an
estimate for normal profit in the average total cost curve,
thus, if the firm covers its AC then it is making normal
profits.
Sub-normal profit - profit less than normal (P < average cost)
Abnormal profit
 Any profit achieved in excess of normal profit - also
known as supernormal profit. When firms are making
abnormal profits, there is an incentive for other producers
to enter a market to try to acquire some of this profit.
 Abnormal profit persists in the long run in imperfectly
competitive markets such as oligopoly and monopoly
where firms successfully block the entry of new firms
Calculating Economic Profit
The data below is for an owner-managed firm for a given year
 Total revenue £320,000
 Raw material costs £30,000
 Wages and salaries £85,000
 Interest paid on bank loan £30,000
 Salary the owner could have earned elsewhere £32,000
 Interest forgone on capital invested £20,000
In a simple accounting sense, the business has total revenue of
Spotify reaches the Break-Even Point
Founded in 2006 and launched in 2008,
it has taken five years for online music
business Spotify to travel from the
point of concept to break-even. Spotify
has grown using the “Freemium” model
whereby a user-base is built by offering
a basic service for free. Revenues are
then built by offering paid-for premium
services to customers.
With Spotify, users can register either
for free accounts supported by
advertising or for paid subscriptions
without ads and with a range of extra
features such as higher bit rate streams
and offline access to music. A paid
“Premium” subscription is required to
use Spotify on mobile devices.
BSkyB Announces Record Profits
BSkyB has announced record revenues
and profits. Total revenue in the last
year grew by 7% to reach £7,235m and
operating profit was 9% higher at
£1,330m. This gave the business an
operating margin of 18.4% and helped
the business to generate free cash flow
of just over £1 billion. Revenue per
subscriber increased by £29 to £577.
BSkyB has 11.2 million customers.
Programming costs were 34% of sales
revenue at £2,486m. Sky paid £59m in
the last year for the right to offer live
coverage of the Ryder Cup, the Lions
Tour and Formula 1. It has also
invested more than £55m this year in
original comedy and drama.

40. © Tutor2u Limited 2013 40
£320,000 and costs of £145,000 giving an accounting profit of £175,000. But profit according to an
economist should take into account the opportunity cost of the capital invested and the income that the
owner could have earned elsewhere. Taking these two items into account we find that the economic profit is
£123,000.
Accounting Profit and Economic Profit
Short Run Profit Maximisation
Profits are maximised when marginal revenue = marginal cost
Price Per Unit (AR)
(£)
Demand /
Output
(units)
Total
Revenue (TR)
(£)
Marginal
Revenue (MR)
(£)
Total
Cost (TC)
(£)
Marginal
Cost (MC)
(£)
Profit
(£)
50 33 1650 2000 -350
48 39 1872 37 2120 20 -248
46 45 2070 33 2222 17 -152
44 51 2244 29 2312 15 -68
42 57 2394 25 2384 12 10
40 63 2520 21 2444 10 76
38 69 2622 17 2480 6 142
36 75 2700 13 2534 9 166
34 81 2754 9 2612 13 142
Consider the example in the table above. As price per unit declines, so demand expands. Total revenue
rises but at a decreasing rate as shown by the column showing marginal revenue. Initially the firm is making
a loss because total cost exceeds total revenue. The firm moves into profit at an output level of 57 units.
Thereafter profit is increasing because the marginal revenue from selling units is greater than the marginal
cost of producing them. Consider the rise in output from 69 to 75 units. The MR is £13 per unit, whereas
marginal cost is £9 per unit. Profits increase from £142 to £166.
But once marginal cost is greater than marginal revenue, total profits are falling. Indeed the firm makes
a loss if it increases output to 93 units.
Accounting Profit
Accounting Cost
Total
Revenue
Economic Profit =
abnormal Profit
Normal Profit =
Opportunity Cost
Accounting Cost
Economic
Cost

41. © Tutor2u Limited 2013 41
Showing profit maximisation in a diagram – the importance of marginal revenue and marginal cost
As long as marginal revenue > marginal cost, total profits will be increasing (or losses decreasing). The profit
maximisation output occurs when marginal revenue = marginal cost.
In the next diagram we introduce average revenue and average cost curves into the diagram so that, having
found the profit maximising output (where MR=MC), we can then find (i) the profit maximising price (using
the demand curve) and then (ii) the cost per unit.
 The difference between price and average cost marks the profit margin per unit of output.
 Total profit is shown by the shaded area and equals the profit margin multiplied by output
Profits are
decreasing when
MR < MC
Marginal Revenue
Marginal Cost
Q1
Revenue
And Cost
Output (Q)
Profits are
increasing
when MR > MC
Marginal profit: the
increase in profit when
one more unit is sold or
the difference between
MR and MC
Costs
Revenue
Output (Q)
AR
(Demand)
MR
SRMC
Q1
P1
AC1
Supernormal profits at
Price P1 and output Q1
AC2
Q2
Normal profit at Q2 where
AR = AC
SRAC

42. © Tutor2u Limited 2013 42
The Short Run Supply Decision - The Shut-down Price
A business needs to make at least normal profit in the long run to justify remaining in an industry but in the
short run a firm will continue to produce as long as total revenue covers total variable costs or price per
unit > or equal to average variable cost (AR = AVC). This is called the short-run shutdown price.
The reason for this is as follows. A business’s fixed costs must be paid regardless of the level of output. If we
make an assumption that these costs cannot be recovered if the firm shuts down then the loss per unit would
be greater if the firm were to shut down, provided variable costs are covered.
 Average revenue (AR) and marginal revenue curves (MR) lies below average cost, so whatever
output produced, the business faces making a loss
 At P1 and Q1 (where marginal revenue equals marginal cost), the firm would shut down as price is
less than AVC. The loss per unit of producing is distance AC. No contribution is made to fixed costs
 If the firm shuts down production the loss per unit will equal the fixed cost per unit AB.
 In the short-run, provided that the price is greater than or equal to P2, the business can justify
continuing to produce
 In the long run the shut down price is where AVC=P because all cost are variable
Recession and factory closures
 The concept of the shutdown point has become topical due to the recession and the weak
subsequent recovery
 Many businesses have opted to close down loss-making production plants and retailers have
announced the closure of retail outlets in a bid to cut their losses.
 Some of the plant closures have been temporary, for example some high-profile car manufacturers
mothballed their factories and reduced the number of shifts. But for other businesses, the downturn
brought about an end to trading. We have seen the demise of a large number of well-known retail
businesses.
Costs,
Revenues
Output (Q)Q1
MC
AVC
AR
MR
P1
AC1
A
B
C
P1 is below average variable cost
- staying in production means that
losses would increase.
P2
ATC

43. © Tutor2u Limited 2013 43
Blockbuster goes bust
The US parent company of the Blockbuster rental company has gone into bankruptcy.
In the early days of the internet, it was thought that a High Street presence was important to complement trading
via the internet.
But Blockbuster has gone, and so have Barnes and Noble. Meanwhile, Love Film and Amazon continue to grow at
a rapid rate. So a place on the High Street can’t be essential. Is it even desirable?
Blockbuster might yet last a while in the UK (where it continues as a franchise set up). But in the US the business
was trapped by two competitors. One force is the online competitor Netflix and the other was Redbox which rents
films for one dollar a night through kiosks in convenience stores.
Netflix has a vast selection of DVDs and is promoting the online streaming of older films, which subscribers will
increasingly be able to obtain through internet-connected television sets. Redbox, in contrast, focuses on big films
and recently-released DVDs which it rents out from vending machines for $1.
Blockbuster was crushed in the middle.
Source: Tom White, Tutor2u
Analysis: Deriving the Firm’s Supply Curve in the Short Run
1. In the short run, the supply curve for a business operating in a competitive market is the marginal
cost curve above average variable cost.
2. In the long run, a firm must make a normal profit, so when price = average cost, this is the break-
even point. It will therefore shut down at any price below this in the long run.
3. As a result the long run supply curve will be the marginal cost curve above average total cost.
The concept of a ‘supply curve’ is inappropriate when dealing with monopoly because a monopoly is a price-
maker, not a “passive” price-taker, and can thus select the price and output combination on the demand
curve so as to maximise profits where marginal revenue = marginal cost.
Analysis: Using Diagrams to show the effects of Changes in Demand and Supply Conditions
 A change in demand and/or costs will lead to a change in the profit maximising price and output.
 In exams you may often be asked to analyse how changes in demand and costs affect the
equilibrium output for a business. Make sure that you are confident in drawing these diagrams and
you can produce them quickly and accurately under exam conditions.
 In the diagram below we see the effects of an outward shift of demand from AR1 to AR2 short run
costs of production remain unchanged). The increase in demand causes a rise in the price from P1
to P2 (consumers are now willing and able to buy more at a given price) and an expansion of supply
(the shift in AR and MR is a signal to firms to move along their marginal cost curve and raise output).
Total profits have increased

44. © Tutor2u Limited 2013 44
What are the Key Functions of Profit in a Market Economy?
Profits serve a variety of purposes in a market economy:
1. Finance for investment Retained profits are source of finance for companies undertaking
investment. The alternatives such as issuing new shares (equity) or bonds may not be attractive
depending on the state of the financial markets especially in the aftermath of the credit crunch.
2. Market entry: Rising profits send signals to other producers within a market. When existing firms
are earning supernormal profits, this signals that profitable entry may be possible. In contestable
markets, we would see a rise in market supply and lower prices. But in a monopoly, the dominant
firm(s) can protect their position through barriers to entry.
3. Demand for factor resources: Scarce factor resources flow where the expected rate of return or
profit is highest. In an industry where demand is strong more land, labour and capital are then
committed to that sector.
4. Signals about the health of the economy: The profits made by businesses throughout the
economy provide important signals about the health of the macro economy. Rising profits might
reflect improvements in supply-side performance (e.g. higher productivity or lower costs through
innovation). Strong profits are also the result of high levels of demand from domestic and overseas
markets. In contrast, a string of profit warnings from businesses could be a lead indicator of a
macroeconomic downturn.
Costs
Output (Q)
AC
AR1
(Demand)
MR1
MC
Q1
P1
AC1
Profit Max at Price P1
P2
AC2
Q2
Profit Max at Price P2
AR2
MR2
A rise in demand (causing an outward shift in AR and MR) causes an expansion of supply, a higher
profit maximising price and an increase in supernormal profits

45. © Tutor2u Limited 2013 45
Index of output at constant prices
UK Oil and Gas Extraction
Source: Reuters EcoWin
76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12
0
25
50
75
100
125
150
175
200
Index
0
25
50
75
100
125
150
175
200
Case Study: Prices, Profits and Incentives –
Investment in North Sea Oil and Gas
Record levels of capital investment will flow into the North
Sea this year as 14 new oilfields come into production,
triggering a historic rise in oil and gas output after more
than a decade of decline. It is estimated that 470m barrels
of oil and gas will come on stream in 2013 – a fivefold
increase on the average over the past three years.
That is a remarkable turnaround for a basin largely written
off as a spent force by some of the world’s largest oil
companies barely a decade ago.
One of the reasons North Sea oil production has gone on much longer than anyone expected is the
emergence of new sub-surface technology that has helped extract reserve long considered uneconomic.
Many oil and gas fields now coming into production were left in the ground because the marginal cost of
extraction was considered too high.
Since 1977, British oil extracted from the North Sea has given a huge boost to the country’s economy,
supplying tax revenues equal to about 27 per cent of gross domestic product.
After peaking in 1999 at 4.5m boe/d, UK oil and gas production has been in steady decline. Geological
research suggests that 20bn barrels of oil are still to be extracted and some models suggest that the North
Sea Continental Shelf will be yielding oil and gas in 30 years’ time.
The international price of crude oil has remained at or around $100per barrel for the last three years and this
high price has also been a factor boosting the profitability of crude oil extraction.
This mix of demand and
supply-side factors helps to
explain the rise in planned
capital spending in the North
Sea oil and gas industry.
A combination of high oil
prices, better technology and
some generous tax breaks
have made it economic to lift
deposits that were previously
known about, but which were
deliberately left in the ground
because, at the time, the cost
of extraction was too high.
Adapted from news reports, July
2013

46. © Tutor2u Limited 2013 46
Case Study: Pricing Models in the App Industry
The global app economy was worth $53Bn in 2012, and expected to rise to $143Bn in 2016. It is an industry
experiencing rapid growth but also considerable upheaval and disruption as new app developers arrive and
pricing models for different apps appear to change with increasing frequency.
Developers of apps have different price points and business models:
1. Free app to download and free to use
2. Free to download + in-app purchases (typically in-game items, more functions or features, ad free)
3. Paid-for using upfront payment only
4. Paid-for using upfront payment + optional in-app purchases
The 3rd and 4th examples described above are called "Freemium apps" and have become increasingly
popular as a pricing model well beyond the realms of the app industry.
A study of the app industry in Germany, the UK and the United States in 2012 found that Freemium apps
accounted for around 1/3rd of the analysed apps in all three countries. Paid apps with just upfront payment
held the largest share with almost 40% but free to download with or without optional in-app payments are
becoming more popular over time? Games in particular rely heavily on Freemium models. News category
apps tend to focus more on upfront payments only with few extras.
A study of 2,400 apps across the three countries found that average prices are similar in all countries.
Productivity apps tend to have the highest prices, games and social network apps the lowest.
Most expensive paid-for apps in the UK
 Games: Football Manager Handheld £6.99
 News: Monocle 24 £4.99
 Productivity: Omni Focus for iPhone £13.99
 Social Networks: mBoxMail - Hotmail with Push £6.99
Freemium apps
Upfront price + in-app price: Amazing Spiderman £4.99 + Huge S Asphalt 7: Heat £69.99
Free to download + in-app purchases:
 The Economist £159.99
 Pro 50 DropBox £69.99
 6 months Zoosk for iPhone & iPad £89.99
Many factors have to be taken into account when setting the pricing model and price point for an app. These
include the prices charged by competitor products, the social and economic background of the user base
and also consumer sensitivity to price changes both for upfront charges and in-app purchases. For many
app developers, frequent testing of different prices enables them to find an equilibrium that meets their
financial targets. But too many price changes risks confusing and alienating customers.

47. © Tutor2u Limited 2013 47
9. Divorce between Ownership and Control
Ownership and control
 The owners of a private sector company normally elect a board of directors to control the
business’s resources for them.
 However, when the owner sells shares, or takes out a loan or bond to raise finance, they may
sacrifice some of their control. Other shareholders can exercise their voting rights, and providers
of loans often have some control (security) over the assets of the business
 This may lead to conflict between them as these different stakeholders may have different
objectives. The flow chart below attempts to show the divorce between ownership and control.
The Principal Agent Problem
How do the owners of a large business know that the managers they have employed operate with the aim of
maximising shareholder value in both the short term and the long run? This lack of information is known as
the principal-agent problem or “agency problem”.
 The principal agent problem revolves around a simple issue - how best to get your employees to
act in your interests rather than their own?
 Shareholders tend to want good returns in the form of dividend payments and a rising share price.
 Managers may have different objectives such as power, bonuses, large expense accounts, prestige
and status. The problem is the many shareholders - have no day-to-day control over managers.
Pension fund managers cannot dictate what CEOs and CFOs of businesses decide to do and senior
executives may have little knowledge of what their managers are doing.
 Many investors in a business are 'passive'. The biggest investors in UK listed companies tend to be
large institutional shareholders such as pension funds and insurance companies.
Principals:
Shareholders
Control Mechanisms:
Pressures from the stock market
and from hedge funds and private
investors
Regular meetings with
shareholders (e.g. the AGM)
Scrutiny in the financial press
Performance related pay (to
provide incentives)
Agents:
Board of Directors
Senior Management
OWNERSHIP
CONTROL

48. © Tutor2u Limited 2013 48
Examples of the principal-agent problem that have hit the headlines recently in the UK include the mis-
management of financial assets on behalf of investors (e.g. Equitable Life.) The classic case in the United
States was the Enron fraud and debacle.
The credit crunch focused attention on the failure of shareholders in the major banks to understand the
complex and risky behaviour that was being undertaken by bank employees involved in the sub-prime
mortgage boom and the growth of securitised lending.
In the banking crisis it became clear that senior management at many of the world's biggest banks simply did
not understand the complexity of what their traders were doing. Traders stood to earn huge bonuses if their
risky loans worked, but faced little sanction or loss if they went bad. This skewed their incentives and created
a problem of moral hazard. This term originated in insurance, recognising the idea that people with
insurance may be careless – for example, paying for secure off-street parking looks less attractive if your car
is insured.
A separation of ownership and control in banks and insurance companies contributed to the sub-prime crisis
and the result has been a collapse in shareholder value as the stock market prices of banks and insurance
companies has fallen sharply.
Employee Share Ownership Schemes
There are various strategies available for coping with the principle- agent problem. One is the expansion of
employee share-ownership schemes. But the use and occasional misuse of share options schemes has
been controversial for several years.
The Growth of "Shareholder Activism"
 Increasingly we are seeing shareholders who are more proactive in putting executive management
under pressure - these are known as activist shareholders. In 2012 some commentators pointed to
the emergence of a “shareholder spring” prompted by investor anger over huge remuneration
packages alongside poor financial performance
 At the forefront of this change has been the expansion of hedge funds and a number of wealthy
private investors. Latterly, the sovereign wealth funds have appeared on the scene.
 An activist shareholder uses an equity stake in a corporation to put pressure on its existing
management.
 The goals of activist shareholders range from financial (e.g. increase of shareholder value
through changes in dividend decisions, plans for cost cutting or investment projects etc.) to non-
financial (e.g. dis-investment from particular countries with a poor human rights record, or
pressuring a business to speed up the adoption of environmentally friendly policies and build a better
reputation for ethical behaviour, etc.).
 Activist shareholders do not have to hold large stakes in a business to make an impact. Even those
with relatively small stakes or 3 or 4 per cent can launch publicity campaigns and make direct
contact with the senior management. Private equity / hedge funds have been among those most
involved in the rise of shareholder activism. They tend to focus on under-performing businesses
Is this new breed of shareholder activists an important voice and counter-balance to the power of entrenched
management and willing to stand up to corporate corruption and highlight poor management? Can they help
to overcome the principle-agent problem? Or are they aggressive corporate raiders seeking short-term
corporate change merely for their own personal gain?
Environmental groups such as Friends of the Earth have also latched onto the potential for shareholder
activism to impact on businesses especially in the areas of the environmental impact of their business
activities.
It remains the case that ownership and control within British industry is dispersed. Typically the largest
shareholder in any large business listed on the stock market is likely to own a minority of the shares. Majority
ownership by a single shareholder is unusual.

49. © Tutor2u Limited 2013 49
10. Measuring Market Concentration
What do we mean by market concentration?
o The concentration ratio measures the combined market
share of the top ‘n’ firms in the industry.
o Share can be by sales, employment or any other relevant
indicator.
o The value of ‘n’ is often five, but may be three or any other
small number. If the top ‘n’ firms gain a high market share
the industry is said to have become more highly
concentrated.
The Herfindahl-Hirschman Index (HHI)
This is a measure of market concentration. The index is calculated
by squaring the % market share of each firm in the market and
summing these numbers.
For example in a market consisting of only four firms with shares of
30%, 30%, 20% and 20% the Herfindahl Index would be 2600 (900 +
900+ 400+ 400).
 The index can be as high as 10,000 if the market is a pure
monopoly (100*)
 The lower the index the more competitive the market is and
can reach almost zero for perfect competition
 If an industry has 1000 companies each with 0.1% market
share then the index would only be 10 (1000 x 0.1*).
A recent joint OFT / Competition Commission merger guidelines note
in the UK suggested that a market with a HHI measure exceeding
2,000 can be characterised as 'highly concentrated.
For example, if a local radio station market consisted of two
companies with 40 per cent each, and of two companies with 10 per
cent each, it would have an HHI of 3,400
The superior quality and accuracy of the Herfindahl Index over the
simple concentration ratio can be seen when three markets are
examined each with a four firm concentration ratio of 85%.
Assume that in each market the remaining 15% of the market is
controlled by 15 firms each with 1% market share.
1. Market A: 40% 20% 20% 5% = 85% - Herfindahl Index =
2440
2. Market B: 25% 20% 20% 20% = 85% - Herfindahl Index
=1840
3. Market C: 75% 5% 3% 2% = 85% Herfindahl Index = 5678
UK Broadband Market Data
The market share data for July
2011 was as follows:
BT – 29%
Virgin Media – 21.5%
Talk Talk – 21%
Sky – 16%
O2 – 3.5%
Orange – 3.6%
Another way of looking at market
position is the number of
broadband customers. This is a
focus of the battleground between
broadband businesses. They are
fighting to capture market share
as well as increase the total
number of retail customers.
Talk Talk – 4.172 million
BT – 5.832 million
Virgin Media – 4.314 million
BSkyB 3.161 million
O2 – 700,000
Orange – 716,000
UK Supermarket – The Big
Firms (market share in %,
August 2011)
Tesco 30.5
Asda 17.1
Sainsbury's 16.1
Morrisons 11.7
Cooperative 6.9
Waitrose 4.3
Aldi 3.6
Lidl 2.6
Iceland 1.9
Somerfield was bought by the
Co-op in 2008 and some stores
were sold to win approval from
competition regulators

50. © Tutor2u Limited 2013 50
Case Study: Market Concentration in the UK Retail Banking Industry
The banking industry has been subjected to waves of criticism over recent years as the fall-out has
continued from the global financial crisis and the weak economic recovery. Banks have been reluctant to
increase their lending to households and small-medium-sized enterprises and there have been calls for deep
structural changes in the retail banking market focusing on making the market more competitive and socially
responsible. Retail banking in the UK is an oligopoly dominated by a handful of established banks who
command a large market share – the industry is highly concentrated although there are signs of some
challenger banks seeking to establish a foothold in the market.
Personal Current Account Provider 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
The table shows that Lloyds and RBS together account for nearly half of all personal current accounts.
Based on the market share data, the Herfindahl-Hirschman Index (HHI) for the personal current account
market rose in the UK from 1,410 in 2007 to 1,736 in 2010. Remember the rule of thumb that an HHI in
excess of 2,000 indicates a highly concentrated market.
Several challenger banks are attempting to make a profitable entry into the industry – examples include
Virgin Money, Tesco Bank and Metro Bank. But there are sizeable entry barriers into the sector.
Acquiring a licence to accept deposits
Acquiring a licence to be able to lend
Establishing a branch network
Developing a successful brand / customer reputation
Acquiring new customers (depositors and borrowers)
Access to information regarding customers' credit risk
Access to payment networks / customer account info
Costs of meeting regulation requirements

51. © Tutor2u Limited 2013 51
Case Study: Market Concentration in the UK Soft Drinks Market
There are two broad categories of soft drinks: carbonated soft drinks (CSDs) and still drinks. CSDs include
drinks such as colas, fruit flavoured carbonates and lemonade as well as carbonated energy drinks. Still soft
drinks include fruit juice, water, juice drinks, squashes and sports drinks. Retail sales of soft drinks in the UK
amounted to £11.2 billion in the year to December 2012.
Soft drinks producers do not sell directly to final consumers, but rather sell their products to customers who
then sell on to final consumers.
Key Competitors in the UK Market
Coca Cola Britvic AG Barr GlaxoSmithKline Danone Others
Main Brands
Coca-Cola,
Sprite, Fanta, Lilt,
Dr Pepper,
Relentless,
Monster, Oasis,
glaceau vitamin
water, 5 Alive,
Ocean Spray and
Powerade. Coca
Cola also owns
60 per cent of
Innocent soft
drinks
Main Brands
Robinsons, J2O,
Fruit Shoot,
Whites, Britvic,
Purdey’s, Juicy
drench, drench,
Pennine Spring
and Tango
Main Brands
IRN-BRU, Tizer,
D’N’B, KA, Barr’s
Originals,
Strathmore
spring water
Main Brands
Lucozade and
Ribena
Note: April 2013,
GSK announced
plans to de-merge
these two brands
from their company
Main Brands
Evian, Volvic
and Badoit
Main Brands
Red Bull
Nichols
Vimto, Panda,
Ben Shaws &
Dayla
CSD: Carbonated sparkling drinks, TCCC: The Coca Cola Company Private label includes supermarket
own-label products.

52. © Tutor2u Limited 2013 52
Perform Buys Opta to Raise Barriers to Entry
Opta a fast-growing business which supplies data to websites,
broadcast feeds and databases and provides data tools to clubs -
being sold to Russian-owned sports-media company Perform.
According to an industry analyst quoted in a new report, “the deal
makes good strategic sense” and would allow Perform to expand
the services it offers around sports rights. This consolidates its
critical mass in the industry and further raises the barriers to
entry to prospective competitors, of which there are currently
few."
(Adapted from News Reports, July 2013)
11. Barriers to Entry and Exit in Markets
 Barriers to entry are designed to block potential entrants from entering a market profitably.
 They seek to protect the power of existing firms and maintain supernormal profits and increase
producer surplus.
 These barriers have the effect of making a market less contestable - they determine the extent to
which well-established firms can price above marginal and average cost in the long run.
 George Stigler defined an entry barrier as “A cost of producing which must be borne by a firm which
seeks to enter an industry but is not borne by businesses already in the industry”.
 Another Economist, George Bain defined entry barriers as “The extent to which established firms
elevate their selling prices above average cost without inducing rivals to enter an industry”.
Cost advantages and entry barriers
 The Bain interpretation of entry barriers
emphasises the asymmetry in costs that
often exists between the incumbent firm and
the potential entrant
 If the existing businesses have managed to
exploit economies of scale and developed
a cost advantage, this might be used to cut
prices if and when new suppliers enter the
market.
 This is a move away from short-run profit
maximisation objectives – but it is designed
to inflict losses on new firms and protect a dominant position in the long run. The monopolist might
then revert back to profit maximization once a new entrant has been sent packing!
Structural, Strategic and Statutory
Barriers
Another way of categorising entry barriers
which might be helpful for revision is
summarised below:
o Structural barriers (‘innocent’
entry barriers) – arising from
differences in production costs
o Strategic barriers (see the notes
below on strategic entry
deterrence)
o Statutory barriers – these are
entry barriers given force of law
(e.g. patent protection of franchises
such as the National Lottery or
television and radio broadcasting
licences)

53. © Tutor2u Limited 2013 53
Zynga provides social game services with 240 million average
monthly active users over 175 countries. All of its games are free to
play, and it generates revenue through the in-game sale of virtual
goods and advertising.
The business enjoyed significant first mover advantage when their
games became an established and hugely popular presence on
Facebook. But since its stock market debut in December 2011, when
it was valued at £656m the company has struggled to sustain their
success with games like FarmVille and Words With Friends, as web
users have moved to mobile devices.
In March 2012 it bought OMGPOP, the company behind the popular
game Draw Something, for $200m (£131m) but shut that business
less than 12 months later. Recently the company has looked to online
gambling as another revenue stream but with modest results so far.
Entry barriers exist when costs are higher for an entrant than for existing firms – this is shown in the
diagram above.
 The incumbent (existing) monopolist has achieved internal economies of scale so that that its own
LRAC and LRMC are lower than that of a potential entrant
 If the monopolist maintains a profit maximising price of P1, a market entrant could achieve above
normal profits since its costs are lower than the prevailing price.
 At any price below Pe the potential entrant will make a loss – and entry can be blockaded.
Theory of Early Mover or First Mover
Advantage
Sometimes there are sizeable
advantages to being first into a market
– first-movers can establish
themselves, build a customer base and
make life difficult for firms who arrive
later on the scene.
However first mover advantage can
prove to be only a temporary benefit to
businesses that are first to gain
commercially from a new market
opportunity. Consider the Zynga
example shown in the box opposite.
Barriers to Exit – (Sunk Costs)
Whilst textbooks tend to concentrate on
the costs of entering a market, often it
is the financial implications of leaving
an industry that act as one of the most
important barriers – hence we need to
consider exit costs. A good example of
these is the presence of sunk costs.
LRAC = LRMC (Existing
Monopolist)
Monopoly
Demand (AR)
MR
Q1
Revenue
Cost and
Profit
Output (Q)
P1
Pc
Qc
B
A
C
AC = MC (Potential
Entrant into the market)
D

54. © Tutor2u Limited 2013 54
Key Barriers to Entry
Sunk costs cannot be recovered if a business decides to leave an industry. Examples include:
 Capital inputs that are specific to an industry and which have little or no resale value.
 Money spent on advertising, marketing and research and development projects which cannot
be carried forward into another market or industry.
When sunk costs are high, a market becomes less contestable. High sunk costs act as a barrier to entry
of new firms because they risk making huge losses if they decide to leave a market. In contrast, markets
such as fast-food restaurants, sandwich bars, hairdressing salons and local antiques markets have low sunk
costs so the barriers to exit are low.
 Asset-write-offs – e.g. the expense associated with writing-off items of plant and machinery, stocks
and the goodwill of a brand
 Closure or project cancellation costs including redundancy costs, contract contingencies with
suppliers and the penalty costs from ending leasing arrangements for property
 The loss of business reputation and goodwill - a decision to leave a market can seriously affect
goodwill among previous customers, not least those who have bought a product which is then
withdrawn and for which replacement parts become difficult or impossible to obtain.
 A market downturn may be perceived as temporary and could be overcome when the economic
or business cycle turns and conditions become more favourable
Economies of scale Vertical integration Brand loyalty
Control of important
technologies
Expertise and
reputation

55. © Tutor2u Limited 2013 55
Strategic Entry Deterrence
Strategic entry deterrence involves any move by existing firms to reinforce their position against other firms
of potential rivals. There are plenty of examples of this – including the following:
 Hostile takeovers and acquisitions – taking a stake in a rival firm or buying it up!
 Product differentiation through brand proliferation (i.e. investment in developing new products
and spending on marketing and advertising to reinforce consumer / brand loyalty).
 Capacity expansions to achieve lower unit costs from exploiting internal economies of scale.
 Predatory pricing: Predatory behaviour is defined as a dominant company sustaining losses in
the short run with the knowledge it will be able to recoup them once the competition is forced to exit,
and is in breach of the Competition Act 1998. We return to this in the chapter on oligopoly and
cartels.
Strategic barriers may be deemed anti-competitive by the British and EU competition authorities - The
EU Competition Commission has been active in recent years in building cases against European businesses
that have engaged in anti-competitive practices including price fixing cartels.
Smart Wars
A fierce legal battle has been taking place in the global Smartphone industry - it all centres around the
intellectual property built into the latest designs of fast-selling mobile phones across the world. Apple and
Samsung are involved in numerous legal claims and have been counter-suing each other:
Apple’s complaints against Samsung Samsung’s complaints against Apple
 Apple complains that Samsung’s overall
design is too similar to the iPhone –
including the rounded corners and silver
edges
 They claim breach of patents on the
cantilevered push button
 Samsung claims breach of technology
patents for encrypting codes in 3G networks
 Breach of technology for efficient data
transmission

56. © Tutor2u Limited 2013 56
12. Technological Change, Costs and Supply in the Long-run
Innovation and invention
 The Oxford English Dictionary defines innovation as “making changes to something established”
 Invention is the act of “coming upon or finding: discovery”
 Product innovation is often associated with small, subtle changes to the characteristics and
performance of a product.
New markets and “synergy demand”:
 Product innovation creates new markets,
especially when new technology creates
radically different products for consumers
 Innovation is a source of synergy demand e.g.
new smart phones generate increased demand
for apps and peripheral products
Sustaining and disruptive innovations
 Many new products are similar to existing ones
on the market – companies are often satisfied
with “sustaining innovations”
 “Disruptive innovations” upset the status quo.
Joseph Schumpeter said that innovation creates
“gales of creative destruction”.
Examples of disruptive innovations:
o Consider online music download businesses
such as iTunes and Spotify
o Voice over Internet Protocol VoIP e.g. Skype
versus mobile phone providers.
Innovation and dynamic efficiency
 Dynamic efficiency occurs over time and
focuses on changes in consumer choice
available in a market together with the quality/performance of goods and services that we buy.
 Innovation can stimulate improvements in dynamic efficiency, always providing that the innovations
that come to market are appropriate in satisfying our changing needs and wants.
Innovation as a barrier to entry
 Innovation can be a barrier to entry in markets.
 Property rights embedded in product innovations might be protected by patent laws.
The Guardian Changes Direction
Guardian News & Media has announced a
programme to reduce the business’
reliance on print-based publishing and aim
to make it a “digital-first” publisher. This is
an example of the impact of technological
change creating the need for significant
shifts in business strategy. Investment
funds that had previously been allocated to
print publishing will now be allocated to
digital projects.
In the medium to long-term, the Guardian
expects to exit print publishing altogether -
although it hasn't put a time-frame on that
change. GNM aims to double digital
income within five years whilst managing
the decline of amounts earned from print.
The Guardian newspaper itself is already
well progressed in terms of a migration of
readership from print to digital. It currently
sells around 250,000 print copies each
day, compared with an average of over 2
million unique users to its website each
day.

57. © Tutor2u Limited 2013 57
 There can be a “first mover advantage” for
successful innovators that gives them scope to
exploit some monopoly power in a market.
 But high rates of innovation reduce barriers to
entry if they challenge power of well-established
businesses
 Technology may free businesses from a single
source of supply – e.g. Open Source software v
Microsoft
 Technology may not necessarily be a source of
competitive advantage – if competitors exploit it
too
Process innovation
 Process innovations involve changes to the
way in which production takes place, be it on
the factory floor, business logistics or innovative
behaviour in managing employees in the
workplace.
 The effects can be both on a firm’s cost structure
(i.e. the ratio of fixed to variable costs) as well as
the balance of factor inputs used in production
(i.e. labour and capital)
Cost reducing innovations cause an outward shift in market supply and they provide the scope for
businesses to enjoy higher profit margins with a given level of demand. Process innovation should also
lead to a more efficient use of resources.
The diagram above uses cost and revenue curves to show the effect of driving down production costs from
SRAC1 to SRAC2 – leading to lower prices and a higher output. You could also use this diagram to show the
gains in producer and consumer surplus that come from cost-reducing innovation and technological
change. Consumers stand to gain from such innovation in that they should be able to expect lower prices.
This increases their real incomes.
Costs
Output (Q)
SRAC1
SRAC3
AR
(Demand)
MR
MC1
MC2
P1
P2
Q1 Q2
Profit at Price P1
Profit at Price P2
Joseph Schumpeter
Austrian economist Joseph Schumpeter
stated that innovation is the primary
cause of economic progress and
development. Innovation is a process of
‘creative destruction’ in which old ways of
doing things are repeatedly destroyed
and replaced by new, better ways. This
forces existing businesses and industries
to adapt to new conditions by innovating
to keep up or resisting change and risking
being made obsolete.

58. © Tutor2u Limited 2013 58
Case Study: Innovation and the Music
Industry – Rocking to Schumpeter’s Beat
Of the many industries to have been affected by
the relentless progress of technology in recent
years, few have felt the pressure as much as
the music industry. Data from the US shows that
the average American now spends only $26 per
year compared to $71 in 1999. The digital age
has brought about the rapid demise of the CD
as a music medium with the average spend on
CDs falling from $63 to $13 over the same
period.
This is, however, not the first time that the music
industry has suffered this kind of downturn. Average spend dropped by more than a third between 1977 and
1982 before the introduction of CDs led to 15 years of growth in spending. Could we be seeing a similar shift
in buying patterns? It would seem not.
The slide is much deeper and much more prolonged than it was three decades ago. The technology which is
replacing CDs means that files can be shared much more easily with other consumers around the world. An
IFPI report in 2008 estimates that 95% of all downloaded songs are not paid for. It is also the core youth
market which is abandoning the traditional media, one in three 15-24 year olds in Europe uses P2P networks
to access their music. Three times the proportion that consumes music legally.
The impact of this can be seen already. HMV announced earlier this year that it would close 10% of its high
street presence as a result of poor performance. This follows the failure of Woolworths and Zavvi in 2009
and Fopp in 2007. Of course, illegal music downloads are not the only force pressuring the entertainment
retailer. Supermarkets now take more than 25% of music sales. Amazon and Play offer a wider range of
music reducing the need for specialist retailers.
The paid download market is worth $4.2bn and iTunes holds some 70% of it. CD retailers always made the
majority of their revenue from album sales but the a la carte download option means people only pay for the
tracks they want.
Joseph Schumpeter would be happy to see creative destruction so vigorously active and it seems clear that
the days of the high street music retailer are over. Of more concern must be the long term impact of music
piracy. Some 84% of illegal downloader’s say that they believe artists should be paid for what they do and
the vast majority of them would not contemplate stealing music from a shop but the ‘Lure of Free’ when
music is just a click away weakens their resolve.
Source: EconoMax, Mark Seccombe, Easter 2011.

59. © Tutor2u Limited 2013 59
Technology Mechanism How It Creates an Business Advantage Example
A new process Produce faster, at lower cost or better quality Internet banking
Solve a complex problem Do something competitors find hard to master Google search engine
A new product The first product to market The iPod
Protect a valuable idea Have something others can only sell if they
pay for a licence
Pfizer’s Viagra
Rewrite the rules A completely new approach which makes
other products and markets redundant
Digital cameras
Government Policy and Innovation
Supply-side strategies are usually linked directly with attempts to promote more innovative behaviour.
Indeed the focus of government policy is firmly focused on improvements in the microeconomics of markets.
Which policies might encourage more innovation?
o Tax credits / capital investment allowances
o Policies to encourage small business creation and entrepreneurship
o Toughening up of competition policy to expose cartel behaviour, but to allow and promote joint
ventures to fund research and development
o Lower corporation taxes to encourage innovative foreign companies to establish in Britain
o Increased funding for research in our universities
o Lower corporation taxes on profits generated from the exploitation of patents – this is known as a
Patent Box and is geared towards incentivising research and development
Important Developments:
1. Increasingly much innovation is done by smaller firms and by entrepreneurs– indeed
multinational corporations are now out-sourcing their research and development spending to small
businesses at home and overseas – much is being shifted to cheaper locations “offshore”—in India
and Russia. See this article on entrepreneurship in the Economist.
2. Innovation is now a continuous process – in part because the length of the product cycle is
getting shorter as innovations are rapidly copied by competitors, pushing down profit margins and
(according to a recent article in the economist) “transforming today's consumer sensation into
tomorrow's commonplace commodity”
3. Innovation is not something left to chance – the most successful firms are those that pursue
innovation in a systematic fashion – it becomes part of their corporate culture.
4. Demand innovation is becoming more important: In many markets, demand is either stable or in
decline. The response is to go for “demand innovation” - discovering fresh demand from consumers
and adapting an existing product to meet them – the toy industry is a classic example of this.
5. The recession and slow recovery may be a stimulus to innovation; many of the successful ‘new’
products of today were developed and tested during the last recession.

60. © Tutor2u Limited 2013 60
13. Perfect Competition – Economics of Competitive Markets
Perfect Competition – a Pure Market!
 Perfect competition describes a market structure whose assumptions are strong and therefore
unlikely to exist in most real-world markets
 We can take some useful insights from studying a world of perfect competition and then comparing
and contrasting with imperfectly competitive markets and industries
 Economists have become more interested in pure competition partly because of the growth of e-
commerce as a means of buying and selling goods and services. And also because of the
popularity of auctions as a device for allocating scarce resources among competing ends.
What are the main assumptions for a perfectly competitive market?
1. Many sellers in the market - each of whom produce a low percentage of market output and cannot
influence the prevailing market price – each firm in this market is a price taker
2. Many individual buyers - none has any control over the market price
3. Perfect freedom of entry and exit from the industry. Firms face no sunk costs and entry and exit
from the market is feasible in the long run. This assumption means that all firms in a perfectly
competitive market make normal profits in the long run
4. Homogeneous products are supplied to the markets that are perfect substitutes. This leads to
each firms being “price takers” with a perfectly elastic demand curve for their product
5. Perfect knowledge – consumers have all readily available information about prices and products
from competing suppliers and can access this at zero cost – in other words, there are few
transactions costs involved in searching for the required information about prices. Likewise sellers
have perfect knowledge about their competitors
6. Perfectly mobile factors of production – land, labour and capital can be switched in response to
changing market conditions, prices and incentives. We assume that transport costs are insignificant
7. No externalities arising from production and/or consumption

61. © Tutor2u Limited 2013 61
Understanding the real world of imperfect competition!
It is often said that perfect competition is a market structure that belongs to out-dated textbooks and is not
worthy of study! Clearly the assumptions of pure competition do not hold in the vast majority of real-world
markets, for example, some suppliers may exert control over the amount of goods and services supplied and
exploit their monopoly power.
On the demand-side, some consumers may have monopsony power against their suppliers because they
purchase a high percentage of total demand. Think for example about the buying power wielded by the
major supermarkets when it comes to sourcing food and drink from food processing businesses and farmers.
The Competition Commission has recently been involved in lengthy and detailed investigations into the
market power of the major supermarkets.
In addition, there are nearly always some barriers to the contestability of a market and far from being
homogeneous; most markets are full of heterogeneous products due to product differentiation – in other
words, products are made different to attract separate groups of consumers.
Consumers have imperfect information and their preferences and choices can be influenced by the effects
of persuasive marketing and advertising. In every industry we can find examples of asymmetric
information where the seller knows more about quality of good than buyer – a frequently quoted example is
the market for second-hand cars! The real world is one in which negative and positive externalities from
both production and consumption are numerous – both of which can lead to a divergence between private
and social costs and benefits. Finally there may be imperfect competition in related markets such as the
market for key raw materials, labour and capital goods.
Adding all of these points together, it seems that we can come close to a world of perfect competition but in
practice there are nearly always barriers to pure competition. That said there are examples of markets which
are highly competitive and which display many, if not all, of the requirements needed for perfect competition.
In the example below we look at the global market for currencies.
Currency Markets - taking us close to perfect
competition
 The global foreign exchange market is where
all buying and selling of world currencies takes
place. There is 24-hour trading, 5 days a
week.
 Trading volume in the Forex market is around
$3 trillion per day – equivalent to the annual
GDP of France! 31% of global trading takes
place in London alone.
 Most trading in currencies is ‘speculative.’
The main players in currency markets are:
 Banks both as “market makers” dealing in currencies and also as end-users demanding currency for
their own operations.
 Hedge funds and other institutions (e.g. funds invested by asset managers, pension funds).
 Central Banks (including occasional currency intervention in the market when they buy and sell to
manipulate an exchange rate in a particular direction).
 Corporations (for example airlines and energy companies who may use the currency market for
defensive ‘hedging’ of exposures to risk such as volatile oil and gas prices.)
 Private investors and people remitting money earned overseas to their country of origin / market
speculators trading in currencies for their own gain / tourists going on holiday and people traveling
around the world on business.

62. © Tutor2u Limited 2013 62
Why does a currency market come close to perfect competition?
 Homogenous output: The "goods" traded in the foreign exchange markets are homogenous - a US
dollar is a dollar and a euro is a euro whether someone is trading it in London, New York or Tokyo.
 Many buyers and sellers meet openly to determine prices: There are large numbers of buyers
and sellers - each of the major banks has a foreign exchange trading floor which helps to "make
the market". Indeed there are so many sellers operating around the world that the currency
exchanges are open for business twenty-four hours a day. No one agent in the currency market can,
on their own influence price on a persistent basis - all are ‘price takers’. According to
Forex_Broker.net "The intensity and quantity of buyers and sellers ready for deals doesn't allow
separate big participants to move the market in joint effort in their own interests on a long-term
basis."
 Currency values are determined solely by market demand and supply factors.
 High quality real-time information and low transactions costs: Most buyers or sellers are well
informed with access to real-time market information and background research analysis on the
factors driving the prices of each individual currency. Technological progress has made more
information immediately available at a fraction of the cost of just a few years ago. This is not to say
that information is cheap - an annual subscription to a Bloomberg or a Reuter’s news terminal will
cost several thousand dollars. But the market is rich with information and transactions costs for each
batch of currency bought and sold has come down.
 Seeking the best price: The buyers and sellers in foreign exchange only deal with those who offer
the best prices. Technology allows them to find the best price quickly.
What are the limitations of currency trading as an
example of a competitive market?
 Firstly the market can be influenced by
official intervention via buying and selling
of currencies by governments or central
banks operating on their behalf. There is a
huge debate about the actual impact of
intervention by policy-makers in the
currency markets.
 Secondly there are high fixed costs involved
in a bank or other financial institution when
establishing a new trading platform for
currencies. They need the capital
equipment to trade effectively; the skilled
labour to employ as currency traders and
researchers. Some of these costs may be
counted as sunk costs – hard to recover if a decision is made to leave the market.
Despite these limitations, the foreign currency markets take us reasonably close to a world of perfect
competition. Much the same can be said for trading in the equities and bond markets and also the ever
expanding range of future markets for financial investments and internationally traded commodities. Other
examples of competitive markets can be found on a local scale – for example a local farmers’ market where
there might be a number of farmers offering their produce for sale.

63. © Tutor2u Limited 2013 63
Price and Output in the Short Run under Perfect Competition
 In the short run, the interaction between demand and supply determines the “market-clearing”
price. A price P1 is established and output Q1 is produced. This price is taken by each firm. The
average revenue curve is their individual demand curve.
 Since the market price is constant for each unit sold, the AR curve also becomes the marginal
revenue curve (MR) for a firm in perfect competition.
 For the firm, the profit maximising output is at Q2 where MC=MR. This output generates a total
revenue (P1 x Q2). Since total revenue exceeds total cost, the firm in our example is making
abnormal (economic) profits
 In the example below, a fall in market demand can bring about economic losses in the short run
Output (Q)Output (Q)
Market Demand and
Supply
Individual Firm’s Costs and
Revenues
Price (P) Price (P)
Market
Demand
Market
Supply
P1
Q1
AR (Demand) = MR
MC (Supply)
AC
P1
AC1
Q2
Output (Q)Industry Output (Q)
Market Demand and
Supply
Individual Firm’s Costs and
RevenuesPrice (P) Price (P)
MD1
Market
Supply
P1
Q1
AR = MR
MC (Supply)
AC
P1
Q2
MD2
P2
AR2 (Demand) =
MR2
AC2

64. © Tutor2u Limited 2013 64
The Adjustment to Long-run Equilibrium in Perfect Competition
 If most firms are making abnormal profits in the short run, this encourages the entry of new firms
into the industry
 This will cause an outward shift in market supply forcing down the price
 The increase in supply will eventually reduce the price until price = long run average cost. At this
point, each firm in the industry is making normal profit.
 Other things remaining the same, there is no further incentive for movement of firms in and out of the
industry and a long-run equilibrium has been established. This is shown in the next diagram
The entry of new firms – an outward shift in market supply and a fall in the ruling market price
We are assuming in the diagram above that there has been no shift in market demand.
 The effect of increased supply is to force down the price and cause an expansion along the market
demand curve.
 But for each supplier, the price they “take” is now lower and it is this that drives down the level of
profit made towards normal profit equilibrium.
In an exam question you may be asked to trace and analyse what might happen if
1. There was a change in market demand (e.g. arising from changes in the relative prices of
substitute products or complements.)
2. There was a cost-reducing innovation affecting all firms in the market or an external shock that
increases the variable costs of all producers.
Output (Q)Output (Q)
Market Demand and Supply Individual Firm’s Costs and Revenues
Price (P) Price (P)
Market
Demand
Market
Supply
(MS)
P1
Q1
AR1 = MR1
MC (Supply)
AC
P1
Q3
P2 P2
AR2 = MR2
Q2
MS2
P2
Long run
equilibrium
output

65. © Tutor2u Limited 2013 65
Characteristics of Competitive Markets
The common characteristics of competitive markets are:
 Lower prices because of many competing firms. The cross-price elasticity of demand for one
product will be high suggesting that consumers are prepared to switch their demand to the most
competitively priced products in the marketplace.
 Low barriers to entry – the entry of new firms provides competition and ensures prices are kept low
 Lower total profits and profit margins than in markets which dominated by a few firms.
 Greater entrepreneurial activity – the Austrian school of economics argues that competition is a
process. For competition to be improved and sustained there needs to be a genuine desire on
behalf of entrepreneurs to innovate and to invent to drive markets forward and create what Joseph
Schumpeter called the “gales of creative destruction”.
 Economic efficiency – competition will ensure that firms move towards productive efficiency. The
threat of competition should lead to a faster rate of technological diffusion, as firms have to be
responsive to the changing needs of consumers. This is known as dynamic efficiency.
Perfect Competition and Economic Efficiency
Perfect competition can be used as a yardstick to compare with other market structures because it displays
high levels of economic efficiency
1. Allocative efficiency: In both the short and long run we find that price is equal to marginal cost
(P=MC) and thus allocative efficiency is achieved. At the ruling price, consumer and producer
surplus are maximised. No one can be made better off without making some other agent at least as
worse off – i.e. we achieve a Pareto optimum allocation of resources.
2. Productive efficiency: Productive efficiency occurs when the equilibrium output is supplied at
minimum average cost. This is attained in the long run for a competitive market. Firms with high unit
costs may not be able to justify remaining in the industry as the market price is driven down by the
forces of competition.
Costs
Revenues
Output (Q)
AR (Demand)
MC (Supply)
P1
Q1
Consumer
Surplus (CS)
Producer
Surplus (PS)
P2
Q2
Net Loss of Economic
Welfare from price P2
raised above marginal cost
Market equilibrium output where
demand = supply and where price
= marginal cost of production

66. © Tutor2u Limited 2013 66
3. Dynamic efficiency: We assume that a perfectly competitive market produces homogeneous
products – in other words, there is little scope for innovation designed purely to make products
differentiated from each other and allow a supplier to develop and then exploit a competitive
advantage in the market to establish some monopoly power.
Some economists claim that perfect competition is not a good market structure for high levels of research
and development spending and the resulting product and process innovations. Indeed it may be the
case that monopolistic or oligopolistic markets are more effective long term in creating the environment for
research and innovation to flourish. A cost-reducing innovation from one producer will, under the assumption
of perfect information, be immediately and without cost transferred to all of the other suppliers.
That said a contestable market provides the discipline on firms to keep their costs under control, to seek to
minimise wastage of scarce resources and to refrain from exploiting the consumer by setting high prices and
enjoying high profit margins. In this sense, competition can stimulate improvements in both static and
dynamic efficiency over time.
The long run of perfect competition, therefore, exhibits optimal levels of economic efficiency. But for this to
be achieved all of the conditions of perfect competition must hold – including in related markets.
Case Study: Price Wars in the Budget Hotel Market
The UK budget hotel industry is dominated by two firms: Travelodge (582 hotels) and Premier Inn (377 hotels). This
duopoly is in the midst of a profit-slashing price war. Premier Inn is selling rooms over the starting at £29 per night,
prompted by falling occupancy rates due to the recession. Travelodge has responded in predictable fashion by offering a
proportion of its rooms at just £19 per night for the same period.
As prices come down on hotel rooms, not only will consumer surplus rise for those who had intended to stay away, but
customers who would otherwise have been priced out of the market can now participate. Thus, total consumer welfare
will rise in the short term. This conclusion assumes that the quality of the rooms available does not alter as a result of the
price war; there may be a chance that quality will suffer as costs must fall in order to remain profitable. Large companies
such as Travelodge should be able to bear short-term losses. However, the much smaller companies that also make up
this duopolistic market may be priced out of the market, and may not survive. In the longer-term, the reduction in
competition and choice for consumers may lead to higher prices and lower quality, as supply falls.
In addition, a fall in price will lead to a fall in revenue earned if demand is relatively price inelastic. Many consumers use
budget hotel rooms out of necessity (e.g. breaking up long journeys). Demand for budget rooms is also closely linked to
the price of car transport, which remains relatively high in the UK; a fall in price, therefore, is unlikely to lead to a more
than proportionate rise in demand. Since we can also probably safely assume that costs have not fallen, then ultimately
profits will fall. Exacerbating this outcome is the possibility of the price-anchoring effect taking hold, as consumers come
to expect very low prices for budget hotel rooms, thus preventing the price from rising again in the future. Furthermore,
once consumer confidence and income starts to noticeably rise again, it is likely that consumers will increase their
demand for higher quality hotel rooms, rather than budget hotel rooms.
Consumers are the winners in the short-term from price wars. In the longer term, however, it is difficult to see precisely
how a price war generates benefits to either consumers or businesses. It will be interesting to see whether the pillow fight
between Travelodge and Premier Inn ends in a room full of feathers.
Source: Ruth Tarrant, EconoMax, Easter 2010

67. © Tutor2u Limited 2013 67
14. Monopolistic Competition
Introducing Monopolistic Competition
 Monopolistic competition is a form of imperfect competition and can be found in many real world
markets ranging from clusters of sandwich bars, other fast food shops and coffee stores in a busy
town centre to pizza delivery businesses in a city or hairdressers in a local area. Small-scale
nurseries and care homes for older people might also fit into the market structure known as
monopolistic competition
 Monopolistic competition is similar to perfect competition, some economist regard it as more realistic,
because the products are differentiated
Short run price, output and profit under monopolistic competition
The assumptions of monopolistic competition are as follows - as you check through them, look to see the
differences between this mark structure and perfect competition.
1. There are many producers and many consumers - the concentration ratio is low
2. Consumers perceive that there are non-price differences among products i.e. there is product
differentiation – competition is strong, plenty of consumer switching takes place
AC1
P1
MR
AR
Price and
Cost
Quantity of Output
AC
MC
Q1

68. © Tutor2u Limited 2013 68
3. Producers have some control over price - they are “price makers” not “price takers” but the price
elasticity of demand is higher than it would be under a situation of monopoly
4. The barriers to entry and exit into and out of the market are low
In the short run the profits made by businesses competing in this type of market structure can be at any
level - in our example above the business is making supernormal profits indicated by the shaded area.
Strong brand loyalty can have the effect of making demand less sensitive to price i.e. lowering the PED
Unlike monopoly, there are no barriers to entry. This means that the short run supernormal profit attracts
new producers into the market, and so normal profits only are made in the long run
As more firms enter the market, the demand curve facing any existing firm moves to the left (as consumers
choose the products offered by new or alternative companies).
The demand curve continues to move to the left until it is tangential to the AC curve. At this point, the
monopolistically competitive firm is at its profit-maximising level of output (because MR = MC) but is making
normal profit (because AR = AC)
Long run price and output equilibrium with monopolistic competition
 The long run equilibrium may be as shown in our second diagram shown below - The
representative firm in the market is making normal profits
 The reality is that a stable equilibrium is never reached - new products come and go all of the time,
some do better than others. Existing products within a market will typically go through a product life
cycle that affects the volume and growth of sales.
One of the implications of monopolistic competition is that an inefficient outcome is reached.
 Prices are above marginal cost – meaning that the equilibrium is not allocatively efficient
 Saturation of the market may lead to businesses being unable to exploit fully economies of scale -
causing average cost to be higher than if less firms and products were in the market
 Critics of heavy spending on marketing and advertising argue that much of this spending is wasted
and is an inefficient use of scarce resources. The debate over the environmental impact of
packaging is linked strongly to this aspect of monopolistic competition
P2 = AC2
MR
AR
Price and
Cost
Quantity of Output
AC
MC
Q2

69. © Tutor2u Limited 2013 69
15. Model of Pure Monopoly
o A pure monopolist in an industry is a single seller. It is quite rare for a firm to have a pure
monopoly – except when the industry is state-owned and has a legally protected monopoly.
o The Royal Mail used to have a statutory monopoly on delivering household mail. But this is now
changing fast as the industry has been opened up to fresh competition.
o A working monopoly: A working monopoly is any firm with greater than 25% of the industries' total
sales. In practice, there are many markets where businesses enjoy some degree of monopoly power
even if they do not have a twenty-five per cent market share.
o A dominant firm is a firm that has at least forty per cent of their given market.
Price and output under a pure monopoly
 A pure monopolist is a single seller in an industry – in this case, the firm is the industry – and it can
take market demand as its own demand curve.
 The firm is a price maker but a monopoly cannot charge a price that the consumers in the market
will not bear. In this sense, the price elasticity of the demand curve acts as a constraint on the
pricing-power of the monopolist.
 Assuming that the monopolist aims to maximise profits (where MR=MC), we establish a short run
price and output equilibrium as shown in the diagram below.
 The profit-maximising level of output is at Q1 at a price P1. This will generate total revenue equal to
OP1aQ1, but the total cost will be OAC1aQ. As total revenue exceeds total costs the firm makes
abnormal (supernormal) profits equal to P1baAC1.
 If, at its current level of output a monopolist is on the price-inelastic part of its demand curve, in order
to maximise its profits it should reduce output and raise price
AC
Monopoly demand
(AR) = market
demand
MR
MC
Q1
Monopoly Profit
at Price P1
Revenue
Cost and
Profit
Output (Q)
P1
AC1
b
a

70. © Tutor2u Limited 2013 70
Analysis: The effect of a rise in costs on monopoly price and profits
 In the diagram below we see the effect of a rise in marginal and average costs for a monopoly
supplier
 Both the marginal cost and the average cost curve shift upwards
 We assume that conditions of demand remain the same i.e. now shift in average and marginal
revenue
 The rise in price from P1 to P2 helps the monopolist to absorb some of the rise in costs, but the net
effect is a reduction in profits and a contraction in output from Q1 to Q2.
 The extent to which a business can pass on a rise in costs depends on the price elasticity of demand
– ‘pricing power’ is greatest when demand is price inelastic, i.e. consumers are not price-sensitive.
Price Discrimination
 In our study of the theory of the firm we have assumed so far that a business charges a single price
for its products, naturally the reality is different!
 Most businesses charge different prices to different groups of consumers for the same good or
service! Businesses could make more money if they treated everyone as individuals and charged
them the price they are willing to pay. But doing this involves a cost – so they have to find the right
pricing strategy for each part of the market they serve – their revenues should rise, but marketing
costs will also increase.
 It is important that you understand what price discrimination is, the conditions required for it to
happen and also some of the economic and social consequences of this type of pricing tactic.
AC1
Monopoly
Demand (AR)
MR
MC1
Q1
Monopoly Profit
at Price P1
Revenue
Cost and
Profit
Output (Q)
P1
AC1
AC2
MC2
Q2
P2
AC2
Monopoly Profit
at Price P2

71. © Tutor2u Limited 2013 71
16. Monopoly and Price Discrimination in Markets
What is price discrimination?
 Price discrimination occurs when a business charges a different price to different groups of
consumers for the same good or service, for reasons not associated with costs
 Charging different prices for similar goods is not pure price discrimination. Product differentiation –
gives a supplier greater control over price and the potential to charge consumers a premium price
because of actual or perceived differences in the quality or performance of a good or service
Conditions necessary for price discrimination to work
Here are the main conditions required for discriminatory pricing:
 Differences in price elasticity of demand: There must be a different price elasticity of demand for
each group of consumers. The firm is then able to charge a higher price to the group with a more
price inelastic demand and a lower price to the group with a more elastic demand. By adopting such
a strategy, the firm can increase total revenue and profits (i.e. achieve a higher level of producer
surplus). To profit maximise, the firm will seek to set marginal revenue = to marginal cost in each
separate (segmented) market.
 Barriers to prevent consumers switching from one supplier to another: The firm must be able
to prevent “consumer switching” – a process whereby consumers who have purchased a product
at a lower price are able to re-sell it to those consumers who would have otherwise paid the
expensive price. This can be done in a number of ways, – and is probably easier to achieve with the
provision of a unique service such as a haircut, dental treatment or a consultation with a doctor
rather than with the exchange of tangible goods such as a meal in a restaurant.
o Switching might be prevented by selling a product to consumers at unique moments in time
– for example with the use of airline tickets for a specific flight that cannot be resold under
any circumstances or cheaper rail tickets that are valid for a specific rail service.
o Software businesses such as Microsoft often offer heavy price discounts for educational
users. Office 2007 for example was made available at a 90% discount for students in the
summer of 2009. But educational purchasers must provide evidence that they are students
In summary, price discrimination is easier when there are separate and distinct markets for a firm’s
products and when the price elasticity of demand varies from one group of consumers to another
Examples of price discrimination
(a) Perfect Price Discrimination – or charging whatever the market will bear
 Sometimes known as optimal pricing, with perfect price discrimination, the firm separates the
market into each individual consumer and charges them the price they are willing and able to pay
 If successful, the firm can extract the entire consumer surplus that lies underneath the demand curve
and turn it into extra revenue or producer surplus. This is hard to achieve unless a business has full
information on every consumer’s individual preferences and willingness to pay
 The transactions costs involved in finding out through market research what each buyer is
prepared to pay is the main barrier to a business’s engaging in this form of price discrimination.
 If the monopolist can perfectly segment the market, then the average revenue curve becomes the
marginal revenue curve for the firm. The monopolist will continue to sell extra units as long as the
extra revenue exceeds the marginal cost of production.
In reality, most suppliers and consumers prefer to work with price lists and menus from which trade can
take place rather than having to negotiate a price for each unit bought and sold.

72. © Tutor2u Limited 2013 72
Second Degree Price Discrimination
 This involves businesses selling off packages or blocks of a product deemed to be surplus
capacity at lower prices than the previously published or advertised price. Price tends to fall as the
quantity bought increases.
 Examples of this can be found in the hotel industry where spare rooms are sold on a last minute
standby basis. In these types of industry, the fixed costs of production are high. At the same time
the marginal or variable costs are small and predictable. If there are unsold rooms, it is often in the
hotel’s best interest to offload any spare capacity at a discount prices, providing that the cheaper
price that adds to revenue at least covers the marginal cost of each unit.
 There is nearly always some supplementary profit to be made. Firms may be quite happy to accept
a smaller profit margin if it means that they manage to steal an advantage on their rival firms.
Early-bird discounts – extra cash flow
Customers booking early with carriers such as EasyJet or RyanAir will normally find lower prices if they are
prepared to book early. This gives the airline the advantage of knowing how full their flights are likely to be
and is a source of cash flow prior to the flight taking off. Closer to the time of the scheduled service the
price rises, on the justification that consumer’s demand for a flight becomes inelastic. People who book late
often regard travel to their intended destination as a necessity and they are likely to be willing and able to
pay a much higher price.
Peak and Off-Peak Pricing
 Peak and off-peak pricing and is common in the
telecommunications industry, leisure retailing and
in the travel sector.
 For example, telephone and electricity companies
separate markets by time: There are three rates for
telephone calls: a daytime peak rate, and an off
peak evening rate and a cheaper weekend rate.
Electricity suppliers also offer cheaper off-peak
electricity during the night.
 At off-peak times, there is plenty of spare
capacity and marginal costs of production are low
(the supply curve is elastic)
 At peak times when demand is high, short run supply becomes relatively inelastic as the supplier
reaches capacity constraints. A combination of higher demand and rising costs forces up the profit
maximising price.

73. © Tutor2u Limited 2013 73
Third Degree (Multi-Market) Price Discrimination
This is the most frequently found form of price discrimination and involves charging different prices for the
same product in different segments of the market.
The key is that third degree discrimination is linked directly to consumers’ willingness and ability to pay
for a good or service. It means that the prices charged may bear little or no relation to the cost of production.
The market is usually separated in two ways: by time or by geography. For example, exporters may charge
a higher price in overseas markets if demand is estimated to be more inelastic than it is in home markets.
Supply (Marginal
Cost)
Off-Peak
Demand
Peak Demand
MR Off-Peak
MR Peak
Output Off-Peak Output Peak
Price,
Cost
Output
P1
P2
Market A Market B
MC=AC
QuantityQuantity
Price
Price
Pa
Pb
MRa
MRb ARb
ARa
Profit from selling to market A
– with a relatively elastic
demand – and charging a
lower price
Demand in segment B of the
market is relatively inelastic.
A higher unit price is charged
MC=AC
QbQa
MC=AC

74. © Tutor2u Limited 2013 74
Customer Profiling and Price
Discrimination by Airlines
A new booking system for air tickets known
as New Distribution Capability (NDC) takes
a large amount of information on the
individual profiles of people looking for air
fares on price comparison sites before
making a booking.
The airlines want to offer more pricing
options to passengers such as in-flight
movies and wider seats. At the moment
choice is mostly limited to business or
economy class.
People booking seats could have the option
to give personal details to airlines, such as
nationality, age, marital status, travel
history, shopping history, previously
purchased services, frequent flyer
participation and whether the trip is
intended for business or leisure.
The International Air Transport Association
(IATA) which represents more than 400
airlines, including British Airways,
Lufthansa, Air-France-KL and American
Airlines says this will enable airlines to
recognize and reward customers, and
provide "Amazon-style" personalized offers
Detailed profiling appears to give the
airlines greater scope for engaging in price
discrimination by offering many variations in
fares to different groups of passengers for
what is essentially the same journey or
product. If a passenger prefers a certain
seat, special meal, and other facilities,
under this new system, they will have to
spend extra money.
Adapted from news reports, July 2013
In the peak market the firm will produce where MRa = MC and
charge price Pa, and in the off-peak market the firm will
produce where MRb = MC and charge price Pb. Consumers
with an inelastic demand will pay a higher price (Pa) than those
with an elastic demand who will be charged Pb.
The internet and price discrimination
The rapid expansion of e-commerce using the internet is giving
manufacturers unprecedented opportunities to experiment with
different forms of price discrimination. Consumers on the net
often provide suppliers with a huge amount of information about
themselves and their buying habits that then give sellers scope
for discriminatory pricing. For example Dell Computer charges
different prices for the same computer on its web pages,
depending on whether the buyer is a state or local government,
or a small business.
Two Part Pricing Tariffs
 Another pricing policy is to set a two-part tariff for
consumers.
 A fixed fee is charged + a supplementary “variable”
charge based on units consumed.
 Examples: taxi fares, amusement park charges
 Price discrimination can come from varying the fixed
charge to different segments of the market and in
varying the charges on marginal units consumed (e.g.
discrimination by time).
Product-line pricing
 Product line pricing occurs when there are many
closely connected complementary products that
consumers may be enticed to buy. It is frequently
observed that a producer may manufacture many
related products. They may choose to charge one low
price for the core product (accepting a lower mark-up or
profit on cost) as a means of attracting customers to
the components / accessories that have a much higher
mark-up or profit margin.
 Examples: manufacturers of cars, cameras, razors and
games-consoles. Indeed discriminatory pricing
techniques may take the form of offering the core
product as a “loss-leader” (i.e. priced below average
cost) to induce consumers to then buy the
complementary products once they have been
“captured”.

75. © Tutor2u Limited 2013 75
Key Aims of Price Discrimination
Evaluating some of the Consequences of Price Discrimination – Efficiency and Welfare Issues
Who gains and who loses out from persistent and pervasive price targeting by businesses? To what extent
does price discrimination help to achieve an efficient allocation of resources? There are many arguments on
both sides of the coin – indeed the impact of price discrimination on welfare seems bound to be ambiguous.
Impact on consumer welfare
 Consumer surplus is reduced in most cases - representing a loss of welfare.
 For the majority of buyers, the price charged is well above the marginal cost of supply.
 However some consumers who can now buy the product at a lower price may benefit. Lower-income
consumers may be “priced into the market” if the supplier is willing and able to charge them less.
 Examples might include legal and medical services where charges are dependent on income levels.
 Greater access to these services may yield external benefits (positive externalities) improving
social welfare and equity. Drugs companies might justify selling products at inflated prices in
higher-income countries because they can then sell the same drugs to patients in poorer countries.
Producer surplus and the use of profit
 Price discrimination benefits businesses through higher revenues and profits.
 A discriminating monopoly is extracting consumer surplus and turning it into supernormal profit.
 Price discrimination also might be used as a predatory pricing tactic to harm competition at the
supplier’s level and increase a firm’s market power.
A counter argument is that price discrimination might be a way of making a market more contestable.
 Low cost airlines have been hugely successful by using price discrimination to fill their planes.
 Profits made in one market may allow firms to cross-subsidise loss-making activities/services
that have important social benefits. For example money made on commuter rail or bus services
may allow transport companies to support loss-making rural or night-time services. Without the
ability to price discriminate, these services may have to be withdrawn and jobs might suffer.
 In many cases, aggressive price discrimination is a means of business survival during a recession.
An increase in total output resulting from selling extra units at a lower price might help a monopoly to
exploit economies of scale thereby reducing long run average costs.
Extra Revenue Higher Profit Improved Cash Flow
Use Up Spare
Capacity

76. © Tutor2u Limited 2013 76
17. Monopoly and Economic Efficiency
The Economic Case against Monopoly
 The conventional argument against market power is that monopolists can earn abnormal
(supernormal) profits at the expense of efficiency and the welfare of consumers and society.
 The monopoly price is assumed to be higher than both marginal and average costs leading to a loss
of allocative efficiency and a failure of the market. The monopolist is extracting a price from
consumers that is above the cost of resources used in making the product and, consumers’ needs
and wants are not being satisfied, as the product is being under-consumed.
 The higher average cost if there are inefficiencies in production means that the firm is not making
optimum use of scarce resources. Under these conditions, there may be a case for government
intervention for example through competition policy or market deregulation.
X Inefficiencies under Monopoly
 The lack of competition may give a monopolist less incentive to invest in new ideas. Even if the
monopolist benefits from economies of scale, they have little incentive to control their costs and 'X'
inefficiencies will mean that there will be no real cost savings compared to a competitive market.
 A competitive industry will produce in the long run where market demand = market supply. Consider
the diagrams below. Equilibrium output and price is at Q1 and Pcomp on the left hand diagram and
Pcomp and Q1 on the right hand diagram. At this point, Price = MC and the industry meets the
conditions for allocative efficiency.
 If the industry is taken over by a monopolist the profit-maximising point (MC=MR) is at price Pmon
and output Q2. The monopolist is able to charge a higher price restrict total output and thereby
reduce welfare because the rise in price to Pmon reduces consumer surplus.
 Some of this reduction in welfare is a pure transfer to the producer through higher profits, but some
of the loss is not reassigned to any other agent. This is known as the deadweight welfare loss or
the social cost of monopoly and is equal to the area ABC.
Output (Q)
Competitive Market Pure Monopoly
Price (P) Price (P)
Market
Supply
Market
Demand
Market
Supply
Monopoly
Demand
Q1 Q1
MR
P comp
P mon
Q2

77. © Tutor2u Limited 2013 77
A similar result is seen in the next diagram which makes the assumption of constant long-run average and
marginal costs under both competition and monopoly. The deadweight loss of welfare under monopoly
(whose profit maximising price is P1 and Q1) is shown by the triangle ABC. The competitive price and output
is Pc and Qc respectively.
Output (Q)
Competitive Market Pure Monopoly
Price (P)
Market
Supply
Market
Demand
Market
Supply
Monopoly
Demand
Q1 Q1
MR
P comp
P mon
Q2
Net loss of
consumer surplus
Net loss of
producer surplus
B
C
D
A
LRAC = LRMC
Monopoly
Demand (AR)
MR
Q1
Monopoly Profit
at Price P1
Revenue
Cost and
Profit
Output (Q)
P1
Pc
Qc
B
A
C
Price (P)

78. © Tutor2u Limited 2013 78
Potential Benefits from Monopoly
 A high market concentration does not always signal the absence of competition; sometimes it can
reflect the success of firms in providing better-quality products, more efficiently, than their rivals
 One difficulty in assessing the welfare consequences of monopoly, duopoly or oligopoly lies in
defining precisely what a market constitutes! In nearly every industry a market is segmented into
different products, and globalization makes it difficult to gauge the degree of monopoly power.
What are the main advantages of a market dominated by a few sellers?
Economies of Scale
A monopolist might be better placed to exploit increasing returns to scale leasing to an equilibrium that
gives a higher output and a lower price than under competitive conditions. This is illustrated in the next
diagram, where we assume that the monopolist is able to drive marginal costs lower in the long run, finding
an equilibrium output of Q2 and pricing below the competitive price.
Monopoly Profits, Research and Development and Dynamic Efficiency
 Patents provide legal protection of an idea or process. Generic patents allow legal copying of a
product.
 As firms are able to earn abnormal profits in the long run there may be a faster rate of
technological development that will reduce costs and produce better quality items for consumers.
 Monopoly power can be good for innovation. Despite the fact that the market leadership of firms like
Microsoft, Toyota, GlaxoSmithKline and Sony is often criticised, investment in research and
development can be beneficial to society because they expand the technological frontier and
open new ways to prosperity. Many innovations are developed by firms with patents on ‘leading-
edge’ technologies.
Output (Q)
Competitive Market Pure Monopoly
Price (P) Price (P)
Market
Supply
Market
Demand
Competitive
Supply
(MC)
Monopoly
Demand
Q1 Q1
MR
P comp
P mon
Q2
Monopoly
Supply with
Scale
Economies

79. © Tutor2u Limited 2013 79
Natural Monopoly
There are several interpretations of what a natural monopoly us
1. It occurs when one large business can supply the entire market at a lower price than two or more
smaller ones
2. A natural monopoly is a situation in which there cannot be more than one efficient provider of a
good. In this situation, competition might actually increase costs and prices
3. It is an industry where the minimum efficient scale is a large share of market demand such there is
room for only one firm to fully exploit all of the available internal economies of scale
4. An industry where the long run average cost curve falls continuously as output expands
5. Private utilities are natural monopolies in local markets
The key point is that a natural monopoly is characterized by increasing returns to scale at all levels of
output – thus the long run cost per unit (LRAC) will drift lower as production expands. LRAC is falling
because long run marginal cost is below LRAC. This can be illustrated in the diagram above. There may be
room only for one supplier to fully exploit economies of scale, reach the minimum efficient scale and
achieve productive efficiency.
Because there is no single definition of a natural monopoly, none of the examples below are purely national
monopolies – their cost structure does take them close to a common-sense interpretation:
1. British Telecom building and maintaining the UK telecommunications network for the broadband
industry – especially the ‘final mile’ copper wiring from the local exchanges to each household
2. The Royal Mail’s postal distribution network – collection / sorting / delivery
3. Camelot operating the national network for the UK lottery
4. National Rail owning, maintaining and leasing out the UK rail network
5. National Grid, which owns and operates the National Grid high-voltage electricity transmission
network in England and Wales. Since April 1, 2005 it also operates the electricity transmission
network in Scotland. Owns and operates the gas transmission network (from terminals to
distributors).
6. London Underground, Tyne and Wear Metro
Costs
Output
LRAC
LRMC
SRAC1
SRAC2

80. © Tutor2u Limited 2013 80
Key point: A natural monopoly does not mean that there is only one business operating in the market or that
only one firm can survive in the long run. Indeed there may be many smaller businesses operating profitably
in smaller ‘niche’ segments of a market (however that is defined).
Possible conflicts between economic efficiency and economic welfare
It is often said that a natural monopoly raises difficult questions for competition policy because
 On the one hand – it is more productively efficient for there to be one dominant provider of a
national infrastructure e.g. a rail network or electricity generating system
 Natural monopolies require enormous investment spending to maintain and improve the networks
 Businesses monopoly power (huge barriers to entry) might be tempted to exploit that power by
raising prices and making huge supernormal profits – damaging consumer welfare
The profit-maximizing price is P1 at an output of Q1. Price is well above the marginal cost of supply and
high supernormal profits are made – but output is high too and there is still a sizeable amount of consumer
surplus because of the internal economies of scale that have brought down the unit cost for all consumers.
(We are ignoring the possibility of price discrimination here).
Options for competition policy in industries that resemble a natural monopoly
1. Nationalization: Bringing some of these industries into state ownership
a. Network Rail is a not-for-profit business (formerly Railtrack plc) – nationalized in 2001
b. National Air Traffic Services – Owned by the UK government (49%); The Airline Group
(42%) which is a consortium of British Airways, BMI, easyJet, Monarch Airlines, Thomas
Cook Airlines, Thomsonfly and Virgin Atlantic; BAA (4%); and NATS employees (5%).
2. Price controls by the regulatory agencies
a. For many utilities, the government introduced industry regulators to oversee these
businesses when they were privatized in the 1980s and early 1990s
b. For many years utility businesses were subject to price capping– most of these have now
finished although some remain – for more details – see this link
Costs
Output
LRAC
LRMC
SRAC1
SRAC2
AR
MR
Q1
P1
C1

81. © Tutor2u Limited 2013 81
c. On 26 November 2009 the water regulator Ofwat announced that water bills must be cut by
an average of £3 a year per household over the next five years and that there must be an
extra £1 billion investment by water companies
3. Fines for anti-competitive behaviour: In 2008 the Microsoft computer software company was fined
€1.68 billion by the European Competition Commission for pre-installing its browser, Internet
Explorer, on computers running the Windows operating system. In December 2009, Microsoft
agreed to allow consumers to choose their web browser on setup. Removing the pre-installation of
the software will mean that more firms will be able to enter the market.
4. Introducing competition into the industry -this has been a favoured policy
a. Basically involves separating out infrastructure from the final service to the consumer –
for example:
i. British Telecom was eventually forced to open-up local telecom exchanges and
allow rivals to install equipment (‘unbundling the local loop’) – who then sell services
such as broadband to households – competitors pay BT an access charge designed
to give BT a 10% rate of return from running the network.
ii. BAA: In March 2009 the UK Competition Commission required British Airports
Authority to sell off three of its seven airports, starting with Gatwick and then
Stansted
iii. National Rail runs the network – but train-operating companies have to bid for the
franchise to run passenger services – and the industry regulator can take their
franchise away if the quality of service isn’t good enough. The government took the
East Coast line into public ownership in July 2009 following the financial problems
facing National Express.
iv. Camelot has successfully bid to operate the National Lottery until 2017
Monopoly Power – Economic Efficiency and Welfare - SPEW
Here is a good way to remember some of the issues we have covered regarding monopoly, efficiency and economic
welfare
Service - does the lack of competition affect the quality of service to consumers?
Prices - how high are prices compared to competitive / contestable market
Efficiency - productive, allocative and dynamic
Welfare - what are the overall welfare outcomes? Is there a net loss of welfare in markets dominated by businesses with
monopoly power?
Acknowledged source: Ruth Tarrant

82. © Tutor2u Limited 2013 82
Case Study: BAA’s Monopoly Heads for the
Departure Gate
Reviled by airlines complaining of high charges
and poor service and lambasted by passengers
furious about lost luggage and interminable delays,
British Airports Authority (BBA) the owner and
manager of Heathrow, Gatwick, Stansted,
Glasgow, Edinburgh, Aberdeen and Southampton
has come under huge criticism from passengers,
airlines and other stakeholders. These seven
airports account for 90% of the air passengers
using South East and East Anglian airports and 84% of Scottish air passengers. BAA racked up revenues of
over £2bn in 2007 and an operating profit of close to £400m.
Nearly half of BAA's income came from charges - including landing fees paid by airlines. Over a quarter
comes from their retail division and nine per cent comes from property income. One per cent of income flows
from other traffic charges – for example a charge of £4.48 each time they use the Heathrow Taxi System.
Add in the profits from expensive airport car parking, profits from their stake in Heathrow Express, bureau de
change businesses and duty free, it is not hard to see how BAA is able to generate monopoly profits.
The airlines have complained about the quality of service and the cost of operating at BAA's airports. British
Airways claimed that "BAA’s record at Heathrow has been lamentable and common ownership is the root
cause of the failure to expand Heathrow’s runway capacity.” RyanAir is reported as saying that "“Heathrow is
a mess, passengers continue to be stuck in long security queues at Stansted and Gatwick’s development is
being held back by this over charging monopoly.”
BAA has countered with the claim that "common ownership has yielded benefits for consumers and remains
the best structure for the efficient operation of airports – the most important issue for passengers.” BAA
argues that it has “invested in major new facilities” and that the major problem is that UK airport terminals are
already running at maximum capacity. A second strand of defence from BAA is that the airports they run now
have been starved of investment in the past and this affects their current performance. They claim that
regulatory control from the Civil Aviation Authority (CAA) is damaging. BAA is committed to investing more
than £9.5bn upgrading the three airports over the next 10 years. But the CAA is proposing to lower the cap
on investment returns, to 6.2 per cent from 7.75 per cent, a disincentive to go ahead with capital projects?
A counter argument is BAA has an effective rather than a natural monopoly and that BAA gains more from
the spillover effects that flow from passenger demand exceeding the capacity at Heathrow. Airlines and their
passengers are more or less forced to switch to Gatwick and/or Stansted because Heathrow is completely
chocker! Monopoly power can lead to X-inefficiencies, higher prices and lower levels of innovation. The
passenger experience deteriorates but there is little that they can do about it.
In March 2009, the Competition Commission told BAA that it must sell Gatwick and Stansted airports and
either Edinburgh or Glasgow airport. The report argued that "Under separate ownership, the airport
operators including BAA will have a greater incentive to be far more responsive to their customers, both
airlines and passengers."
Source: Geoff Riley, EconoMax and Tutor2u blogs
BAA told to sell three airports (BBC news)
Competition Commission report on BAA

83. © Tutor2u Limited 2013 83
Case Study Market Power in the UK Private Health Care Industry
Demand for health care treatments grows year by year as the population expands, ages and as incomes
rise. For millions of people private health care is regarded as a necessity even though the NHS provides a
vast range of services free at the point of use. Treatments such as cosmetic surgery, hand surgery, laser eye
treatment, physiotherapy, weight loss services and hip and knee replacements are offered by a range of
private sector providers in addition to state health care facilities.
Private sector companies appear to be making ground in providing a growing range of services for the NHS;
in January 2012 Hinchingbrooke Health Care Trust in Cambridgeshire became the first all-purpose general
hospital to be managed by a private company - Circle. In March 2012 a £500 million, five-year contract to
run a wide variety of community health services in Surrey was won by Virgin Care.
The Office of Fair Trading is referring the private health care sector to the Competition Commission. A recent
OFT market study was initiated in response to a formal complaint from Circle on the anti-competitive nature
of the private healthcare market in September 2010.
Circle is a new entrant into the UK health care sector - it is an employee co-owned partnership and has
quickly become the largest partnership of healthcare professionals in Europe. Circle complained about what
it thought are anti-competitive agreements (or network agreements) between national private healthcare
providers and private medical insurance providers which it claims reduces consumer choice, stifles
innovation (dynamic efficiency) and keeps prices for different treatments at high levels.
Private Health care suppliers
There are five main PH provider groups active in the UK, each of which owns a network of PH facilities
located throughout the UK.
1. General Healthcare Group (GHG) / BMI Health Care: www.generalhealthcare.co.uk and
www.bmihealthcare.co.uk
2. Spire Healthcare (Spire) www.spirehealthcare.com
3. Nuffield Health (Nuffield) www.nuffieldhealth.com/Individuals/Facilities
4. HCA International (HCA) www.hcafacilities.co.uk
5. Ramsay Healthcare (Ramsay) www.ramsayhealth.co.uk
The market is highly concentrated – it is an oligopoly. These top five PH providers accounted for
approximately 77 per cent of the PH market by revenue in 2010

84. © Tutor2u Limited 2013 84
Private Medical Insurance Providers (PMI)
These are insurance companies who attract personal and corporate buyers and who are purchasers of
health care for their insurance holders. There are five main PMI providers active in the UK (the most recent
market share is shown in brackets)
1. Bupa (42%)
2. AXA PPP (26%)
3. Aviva (10%)
4. PruHealth (which owns Standard Life Healthcare) (10%)
5. WPA (3%)
The buying side of the private healthcare market is also highly concentrated. Together, these five PMI
providers account for well over 90% of the total revenue from PMI sales ‘subscription income’. This gives the
private medical insurance businesses significant buying (monopsony) power in the market. For many private
health care providers it is vital for them to be listed on the health care choice options listed by Bupa and AXA
PPP which together account for nearly 70 per cent of PMI funded patients
The OFT has found some market failures in the private health care industry and in April 2012 a decision was
made to refer the market to the UK Competition Commission
The April 2012 Office of Fair Trading report found evidence of
1. Information asymmetries - they claim that there is a lack of easily comparable information available
to patients and their GPs on the quality and costs of private healthcare services. The full costs of
treatment may not always be transparent for private patients and this makes it hard for patients to
know if they are getting value for money. Certain information asymmetries are inevitable in
healthcare markets given that patients are unlikely to know more about their condition than a GP or
other medical professional. Many people do not have the knowledge, experience or time to search
for the most appropriate course of treatment
2. Monopoly control / entry barriers - There are only a limited number of significant private
healthcare providers and larger health insurance providers at a national level. Most patients prefer to
be treated locally but often there is a very limited choice of hospital. The OFT also points to barriers
to entry - there are significant barriers to new competitors entering the market and being able to offer
private patients greater choice. The typical cost for a new two-theatre twenty-bed private health
facility is £21m-£25m. Smaller ten-bed PH facilities could be built for approximately £3-5m. These
costs include capital expenditure, obtaining land and planning permission and meeting regulatory
requirements

85. © Tutor2u Limited 2013 85
18. Oligopoly – Non Collusive Behaviour
What is an oligopoly?
 An oligopoly is an imperfectly competitive industry where there is a high level of market
concentration. Examples of markets that can be described as oligopolies include the markets for
petrol in the UK, soft drinks producers and the main high street banks. In the global market for sports
footwear – 60% is held by Nike and Adidas
 Oligopoly is best defined by the actual conduct (or behaviour) of firms within a market
 The concentration ratio measures the extent to which a market or industry is dominated by a few
leading firms. A rule of thumb is that an oligopoly exists when the top five firms in the market
account for more than 60% of total market sales.
What are the main characteristics of an oligopoly?
An oligopoly usually exhibits the following features:
1. Product branding: Each firm in the market is selling a branded product which is built and protected
by heavy spending on advertising and marketing
2. Entry barriers: Entry barriers maintain supernormal profits for the dominant / established firms. It is
possible for many smaller firms to operate on the periphery of an oligopolistic market, but none of
them is large enough to have any significant effect on prices and output
3. Inter-dependent decision-making: Inter-dependence means that firms must take into account the
likely reactions of their rivals to any change in price, output or forms of non-price competition
4. Non-price competition: Non-price competition is a consistent and crucial feature of the competitive
strategies of oligopolistic firms especially when they are growing or defending market share
There is no single theory of price and output under oligopoly. If a price war breaks out, oligopolists may
produce and price much as a highly competitive industry would; at other times they act like a pure monopoly.
Duopoly
 Duopoly is a form of oligopoly. In its purest form two firms control all of the market, but in reality
the term duopoly is used to describe any market where two firms dominate
 Examples of duopolistic markets: There are many examples of duopoly including the following:
o Coca-Cola and Pepsi (soft drinks), Unilever and Proctor & Gamble (detergents)
o Bloomberg and Reuters (Financial information services), Sotheby’s and Christie’s
(auctioneers of antiques/paintings)
o Airbus and Boeing (aircraft manufacturers)
o US diesel locomotive market is a duopoly of General Electric’s GE Transportation and
Caterpillar’s EMD
o Glencore and Trafigura form a duopoly that controls as much as 60 per cent of some
markets, such as zinc
In these imperfectly competitive markets entry barriers are high although there are usually smaller players
in the market surviving successfully. The high entry barriers in duopolies are usually based on one or more
of the following: brand loyalty, product differentiation and huge research economies of scale.

86. © Tutor2u Limited 2013 86
Analysis: The Kinked Demand Curve Model of Oligopoly
The kinked demand curve model assumes
that a business might face a dual demand
curve for its product based on the likely
reactions of other firms to a change in its
price or another variable.
The common assumption is that firms in an
oligopoly are looking to protect and maintain
their market share and that rival firms are
unlikely to match another’s price increase
but may match a price fall. I.e. rival firms
within an oligopoly react asymmetrically to a
change in the price of another firm.
 If a business raises price and others leave their prices constant, then we can expect quite a large
substitution effect making demand relatively price elastic. The business would then lose market
share and expect to see a fall in its total revenue.
 If a business reduces its price but other firms follow suit, the relative price change is smaller and
demand would be inelastic. Cutting prices when demand is inelastic leads to a fall in revenue with
little or no effect on market share.
The kinked demand curve model makes a prediction that a business might reach a stable profit-
maximising equilibrium at price P1 and output Q1 and have little incentive to alter prices.
 The kinked demand curve model predicts there will be periods of relative price stability under an
oligopoly with businesses focusing on non-price competition as a means of reinforcing their market
position and increasing their supernormal profits.
 Short-lived price wars between rival firms can still happen under the kinked demand curve model.
During a price war, firms in the market are seeking to snatch a short term advantage and win over
some extra market share.
Assume we start out at P1 and Q1:
Will a firm benefit from raising price
above P1?
Will it benefit from cutting price below
P1?
Raising price above P1
Demand is relatively elastic because
other firms do not match a price rise
Firm loses market share and some
total revenue
Reducing price below P1
Demand is relatively inelastic
Little gain in market share – other firms
have followed suit in cutting prices
Total revenue may still fall
Costs
Revenues
Output (Q)
P1
Q1
MR
AR

87. © Tutor2u Limited 2013 87
Recent examples of price wars include the major UK supermarkets, price discounting of computers in China
and a price war between cross channel speed ferry services. Price competition is frequently seen in the
telecommunications industry.
Changes in costs using the kinked demand curve analysis
One prediction of the kinked demand curve model is that changes in variable costs might not lead to a rise or
fall in the profit maximising price and output. This is shown in the next diagram where it is assumed that a
rise in costs such as energy and raw material prices leads to an upward shift in the marginal cost curve from
MC1 to MC2. Despite this shift, the equilibrium price and output remains at Q1. It would take another hike in
costs to MC3 for the price to alter.
There is limited real-world evidence for the kinked demand curve model. The theory can be criticised for
not explaining why firms start out at the equilibrium price and quantity. That said it is one possible model of
how firms in an oligopoly might behave if they have to consider the responses of their rivals.
Importance of Non-Price Competition under Oligopoly
Oligopolistic theory predicts that firms in this market structure
will tend to prefer non-price competition rather than price
competition due to the self-defeating outcome of a price-war.
Non-price competition involves advertising and marketing
strategies to increase demand and develop brand loyalty among
consumers.
Businesses will use other policies to increase market share:
o Better quality of customer service including
guaranteed delivery times for consumers and low-cost
servicing agreements, good after-sales service
o Longer opening hours for retailers, 24 hour online
customer support.
o Discounts on product upgrades when they become available in the market.
Output (Q)
P1
Q1
MR
AR
MC1
MC2
MC3
Increase in marginal cost
from MC1 to MC2 does not
lead to a change in the profit
maximising price and output
P2
Q2
Increase in marginal cost from
MC2 to MC3 does lead to a
change in output and price
Price (P)

88. © Tutor2u Limited 2013 88
o Contractual relationships with suppliers - for
example the system of tied houses for pubs and
contractual agreements with franchises
(offering exclusive distribution agreements). For
example, Apple has signed exclusive
distribution agreements with T-Mobile of
Germany, Orange in France and O2 in the UK
for the iPhone. The agreements give Apple 10
percent of sales from phone calls and data
transfers made over the devices
o BOGOF techniques – buy one, get one free
tactics
o Loyalty cards, free delivery, online ordering,
free gifts, guarantees
Advertising spending runs in millions of pounds for
many firms. Some simply apply a profit maximising rule
to their marketing strategies. A promotional campaign is
profitable if the marginal revenue from any extra sales
exceeds the cost of the advertising campaign and
marginal costs of producing an increase in output.
However, it is not always easy to measure accurately
the incremental sales arising from a specific advertising
campaign. Other businesses see advertising simply as
a way of increasing sales revenue. If persuasive
advertising leads to an outward shift in demand,
consumers are willing to pay more for each unit
consumed. This increases the potential consumer
surplus that a business might extract.
High spending on marketing is important for new
business start-ups and for firms trying to break into an
existing market where there is consumer or brand
loyalty to the existing products in
Brand loyalty
A brand name is a name used to distinguish one
product from its competitors. It can apply to a single
product, an entire product range, or even a company
(e.g. Virgin, Ferrari, Bang and Olufsen)
Brand loyalty is hugely important in all kinds of
industries and markets. The costs of acquiring a new
customer vastly outweigh the expense of selling more to
existing buyers and most of the mobile phone suppliers
in this oligopolistic industry focus an enormous effort in
building brand identity and brand loyalty to reduce the
rate of customer churn (people who switch brands).
When brand loyalty is strong, the cross-price elasticity
of demand for price changes between two substitutes
weakens and fewer consumers will switch their demand
when there is a change in relative prices in the market.
Robust brand loyalty makes it easier to charge premium
prices and enjoy supernormal profits in the long run
because loyalty is a barrier to entry. When we become
strongly attached to a brand, our purchasing decisions
are more likely to stay in default mode and we may no
longer even consider rival products.
Brands and Non Price Competition
Brands provide clarity and guidance for
choices made by companies, consumers,
investors and other stakeholders. They
embody a core promise of values and
benefits consistently delivered and provide
the signposts needed to make decisions
Global Top Brands for 2013
 Apple
 Google
 IBM
 McDonald’s
 Coca Cola
 AT&T
 Microsoft
 Marlboro
 Visa
 China Mobile
 General Electric
 Verizon
 Wells Fargo
 Amazon
 UPS
 Vodafone
 Walmart
 SAP
 MasterCard

89. © Tutor2u Limited 2013 89
Non Price Competition
Competitiveness – a key to success in an oligopoly
Traditionally, the main measures of competitiveness are in financial or marketing terms. For example, a
competitive business might be expected to achieve one or more of the following:
 A higher growth rate (sales, revenues) than competitors and the market as a whole
 Higher-than average net profit margin (compared with others in the same industry)
 Better than average returns on investment – again, compared with competitors
 A high (perhaps leading) market share – measured in either value or volume terms. The leading
firms in a market usually enjoy a significant proportion of the available revenues or customer
demand, unless the market is highly fragmented.
 The strongest brand reputation in the market – e.g. brand awareness
 A clearly defined unique selling point (“USP”) that enables the business to differentiate its product or
service in the eyes of customers
 Significant access to, or control of, distribution channels in the market (e.g. products or brands that
are widely stocked or demanded by intermediaries who provide distribution to the final consumers)
 Better product quality – e.g. reliability, product features, performance
 Better customer service – e.g. after-sales support, customer information, handling of problems &
complaints
 Better than average efficiency – e.g. being able to produce at a lower unit cost than most other
competitors, either though better productivity or economies of scale
Innovation Quality of service Free Upgrades
Exclusivity
International brands are becoming
increasingly owned by a small
number of very large
conglomerates. For instance,
Pepsico, the Coca-Cola
Company, Kraft, Nestle, Mars,
Procter & Gamble, and Unilever
own a staggering number of the
world's most recognisable brands
between them. Unilever, the
Anglo-Dutch conglomerate, owns
over 400 brands by itself (Source:
Linda Yueh, BBC, Dec 2013)

90. © Tutor2u Limited 2013 90
Case Study: Oligopoly and Duopoly in UK Bus
Markets
The UK Competition Commission has published an
important report into the market structure of local and
regional bus services in the UK, twenty-five years after the
industry was deregulated and largely privatised
Largely as a result of a long-term process of consolidation
through merger and acquisition, the UK bus industry is
found to be highly concentrated with five businesses
dominating the sector even though more than 1,200
businesses provide services.
The five largest operators (Arriva, FirstGroup, Go-Ahead,
National Express and Stagecoach) carry 70 per cent of those passengers. The CC also found that head-to-
head competition between operators is un-common and that-on average-the largest operator in an urban
area runs 69 per cent of local bus services - effectively a monopoly position.
Because of the absence of genuine in competition in many towns and cities, the Competition Commission
argued that market power had lead to passengers facing less frequent services and, in some cases, higher
fares than where there is some form of rivalry.
The Commission wants to increase the contestability of the market and proposes better ticketing, better
customer information, and fair access for all operators to bus stations and closer scrutiny of future bus
company mergers. Most areas are served by just one or two operators with a significant share of supply
 Low price elasticity of demand - the report found that changes in the fare or service on existing
services offered by local bus operators had little effect on passengers’ overall use of the bus. It found
that the price elasticity of bus demand, from all individuals in the sample, with respect to bus fares is
–0.36 (i.e. inelastic). No significant differences were found for the time of day suggesting little actual
difference in Ped between peak and off-peak times

91. © Tutor2u Limited 2013 91
 Business stealing effects: The Commission finds this is a key feature of the market; most
customers board the first bus heading towards their destination rather than compare prices between
rival operators. If an operator increases its frequency, the increase in demand for its services will
largely be as a result of customers switching from other operators, rather than as a result of an
increase in the total market demand for bus services.
 Multi-modal competition: The CC report finds that price elasticity of demand for bus service is
always low and nearly always less than -0.5 which provides an opportunity for operators to increase
fares and raise profit margins. But the bus operators claim that multi-modal competition provides a
constraint on their pricing power even when they have a local monopoly. Higher fares might prompt
people to use a car or take local rail and tram services if they are available. Fare rises might also be
limited by the risk of creating adverse publicity in local areas
 Rates of return (profit): Bus operators have earned profits that were persistently above the cost of
capital on a national basis suggesting some supernormal profits for these businesses. The overall
average rate of return on capital employed (ROCE) for the five-year period investigated was 13.5%.
Profitability at the end of the 5 year investigation period were higher than at the start
 Barriers to entry: Sunk costs of bringing a route to profitability are high as are the risks from an
intensity of post-entry competition as incumbent operators react and respond to new bus operators

Competition Commission
concerned about lack of
competition in the UK cement
industry
The Competition Commission (CC) has
finishes a market investigation into the
supply of aggregates, cement and
ready mix concrete (RMX) in Great
Britain and has concluded that
coordination between the three major
cement producers (Lafarge Tarmac,
Cemex and Hanson) in the cement
market is likely to be resulting in higher
prices for all cement users.
The CC’s finding does not relate to explicit
collusion between these producers. Rather,
as the cement market is highly concentrated with only four GB producers (Hope Construction Materials
(HCM) being a new entrant), who have an unusually high level of understanding of each other’s
businesses—this has created conditions which allow three of them to coordinate their behaviour, thereby
softening competition and resulting in higher prices for consumers.
The CC is now looking at a wide range of possible remedies to increase competition in the cement market,
including requiring the major producers to divest (sell) cement plants (and RMX operations as part of the
remedy to coordination in cement).It may also look into the creation of a cement buying group to rebalance
the power in the market between sellers and purchasers.
Despite low demand for cement over recent years, prices and profitability for UK producers have still
increased.
Adapted from news reports, June 2013

92. © Tutor2u Limited 2013 92
19. Oligopoly – Collusion between Businesses
There are a number of models of oligopoly, ranging from
competitive oligopolies where businesses are engaged in price
wars to formal collusion, with firms acting as a cartel engaging in
joint profit maximisation. The majority of oligopoly outcomes in real
world markets and industries are between these extremes, with tacit
collusion or price leadership also possible outcomes.
Collusive behaviour is a common feature of many oligopolistic
markets. In this section we look at different forms of collusion
starting with tacit collusion based around price leadership.
Tacit collusion
 Price leadership refers to a situation where prices and
price changes established by a dominant firm, or a firm are
usually accepted by others and which other firms in the
industry adopt and follow. When price leadership is adopted
to facilitate tacit (or silent) collusion, the price leader will
generally tend to set a price high enough that the least cost-
efficient firm in the market may earn some return above the
competitive level.
 We see examples of this with the major mortgage lenders
and petrol retailers where many suppliers follow the pricing
strategies of leading firms. If most firms in a market are
moving prices in the same direction, it can take some time
for relative price differences to emerge which might cause
consumers to switch their demand.
 Firms who market to consumers that they are “never
knowingly undersold” or who claim to be monitoring and
matching the cheapest price in a given geographical area
are essentially engaged in tacit collusion. Does the
consumer really benefit from this?
When a market is dominated by a few large firms, there is always
the potential for businesses to seek to reduce uncertainty and
engage in some form of collusive behaviour. When this happens the
existing firms engage in price fixing cartels. This behaviour is
deemed illegal by UK and European competition law. But it can be
very hard and complex to prove that a group of firms have
deliberately joined together to increase prices.
Overt or Explicit Price Fixing
 Overt means spoken, open or traceable
 Collusion is often explained by a desire to achieve joint-
profit maximisation within a market or prevent price and
revenue instability in an industry.
 Price fixing represents an attempt by suppliers to control
supply and fix price at a level close to the level we would
expect from a monopoly.
 To collude on price, producers must be able to exert some
control over market supply.
 In the diagram below a producer cartel is assumed to fix the
cartel price at price Pm. The distribution of the cartel output
may be allocated on the basis of an output quota system or
Apple Found Guilty of Price
Fixing in the E-Books Market
A US court has judged that Apple
has broken anti-trust (competition)
law by playing a leading role in a
conspiracy with publishers to
increase the price of eBooks. The
UD Department of Justice ruled that
the price-fixing conspiracy led to a
“dramatic” increase in the average
price of eBooks and cost
consumers hundreds of millions of
dollars.
Apple entered the eBook market
with the 2010 launch of its iPad
and iBookstore. At the time,
Amazon controlled nearly a 90 per
cent share of the digital book
business, buying new eBooks from
publishers for $10, selling them to
consumers for $9.99.
Publishers worried that Amazon’s
pricing model threatened their
business but thought they needed
to act collectively to increase prices
or face retaliation from Amazon,
Apple struck deals that let
publishers set the price, while it
took a 30 per cent cut - this is
known as an agency pricing model.
Publishers also agreed to price caps
and a clause that allowed Apple to
match other retailers’ prices. That
gave them the incentive to strike
new deals with Amazon and others,
which also ended up charging
consumers more.
The pricing model at issue in the
price-fixing case study has largely
been abandoned by publishers as a
result of recent court decisions.

93. © Tutor2u Limited 2013 93
another process of negotiation.
 Although the cartel as a whole is maximising profits, the individual firm’s output quota is unlikely to
be at their profit maximising point. For any one firm, expanding output and selling at a price that
slightly undercuts the cartel price can achieve extra profits!
 Unfortunately if one firm does this, it is in each firm’s interests to do exactly the same and, if all firms
break the terms of their cartel agreement, the result will be excess supply in the market and a sharp
fall in the price. Under these circumstances, a cartel agreement can break down
Main Aims of Price Fixing
Cartel Diagram to show Price Fixing
Businesses recognise their interdependence – act together to maximise joint
profits
Cut some of the costs of competition e.g. marketing wars
Reduces industry uncertainty – higher profits increases producer surplus /
shareholder value
Industry Costs and Revenues
Firms Output Industry Output
MC (industry)
Demand
MR
MC
AC
Quota Industry
Output (Qm)
Pm (cartel)
Pm (cartel)
Price PriceIndividual Firm inside Cartel

94. © Tutor2u Limited 2013 94
Collusion in a market or industry is easier to achieve when:
1. There are only a small number of firms in the industry and there are significant barriers to prevent
new firms entering the industry
2. Market demand is not too variable (or cyclical) i.e. it is reasonably predictable and not subject to
violent fluctuations which may lead to excess demand or excess supply.
3. Demand is fairly inelastic with respect to price so that a higher cartel price increases the total
revenue to suppliers – this is easier when the product is viewed as a necessity.
4. Each firm’s output can be easily monitored (this is important!) – This enables the cartel more
easily to control total supply and identify firms who are cheating on output quotas.
5. Incomplete information about motivation of other firms may induce tacit collusion.
Possible Break-Downs of Cartels
Most cartel arrangements experience difficulties and tensions and some cartels collapse completely. Several
factors can create problems within a collusive agreement between suppliers:
1. Enforcement problems: The cartel aims to restrict production to maximize total profits of members.
But each individual seller finds it profitable to expand production. It may become difficult for the cartel
to enforce its output quotas and there may be disputes about how to share out the profits. Other
firms – not members of the cartel – may opt to take a free ride by selling just under the cartel price.
2. Falling market demand creates excess capacity in the industry and puts pressure on individual
firms to discount prices to maintain their revenue
3. The successful entry of non-cartel firms into the industry undermines a cartel’s control of the
market. Rapid technological change can often undermine a cartel e.g. a new entrant with an
innovative and success alternative business model.
4. The exposure of illegal price-fixing by market regulators such as UK Office of Fair Trading and
the European Competition Commission. The Office of Fair Trading can fine a company up to 10 per
cent of its global turnover in a particular sector if it is found to be part of a cartel.
5. The exposure of price-fixing by whistle-blowing firms – these are firms previously engaged in a
cartel that decides to withdraw from it and pass on information to the competition authorities
Summary of why many price-fixing cartels break down
Falling market demand Over-production
Exposure by authorities Entry of non-cartel firms

95. © Tutor2u Limited 2013 95
Case Study: Potash Cartel Threatens to Collapse
World prices for potash - a vital ingredient in manufacturing fertilizer - are expected to fall sharply after a
leading Russian producer of potash announced that it was leaving one of the two big cartels controlling the
potash market. Uralkali is pulling out of the Belarus Potash Corporation export cartel after it accused its
Belarusian partner of violating an agreement and selling outside the partnership.
Potash, which is mined from deep underground, is expensive to produce and requires massive scale and
huge new investment to bring on new mines. The potash industry has been dominated by two informal
cartels: Belarusian Potash Company, representing Uralkali and Belaruskali, and Canpotex, the North
American export cartel which includes PotashCorp, Mosaic and Agrium. With 70 per cent of the market
under their control, the cartels cut production during times of weak demand, keeping prices from falling
sharply.
The two potash cartels have maintained market prices
well above marginal production costs by refraining from
flooding the market. In 2008, when the world price for
potash jumped 10-fold to almost $1,000 a tonne, the
fertilizer industry attracted new businesses including
mining companies such as BHP and other entrants
piling in with development projects to unearth new
supplies of potash. This has included projects to mine
potash in North Yorkshire.
Many of the hugely expensive green-field projects under
consideration rely on a potash price of $450 per tonne
or more to deliver satisfactory rates of return on
investment. A fragmentation of the cartel might mean that international potash prices could fall from about
$400 to $300 per tonne after the change in strategy which could inflict economic losses on new entrants into
the potash industry.
However a price drop would be good news for farmers as it should in theory lead to a reduction in the price
of fertilizer. For example, fertilizer is 25 to 30 percent of the cost of grain production in the United States.
China, which has 20 per cent of the world’s population but only 10 per cent of its arable land, has long been
trying to bring potash prices down. China buys about 5m tonnes of potash a year and in 2012, China used
monopsony power to obtain potash price discounts after staging a buyer’s strike that lasted several
months.
Source: Adapted from news reports, July/August 2013

96. © Tutor2u Limited 2013 96
20. Oligopoly - Game Theory
Game Theory
 Game theory is mainly concerned with predicting the
outcome of games of strategy in which the participants
(for example two or more businesses competing in a
market) have incomplete information about the others'
intentions.
 Game theory analysis has direct relevance to the study
of the conduct and behaviour of firms in oligopolistic
markets – for example the decisions that firms must take
over pricing and levels of production, and also how much
money to invest in research and development spending.
 Costly research projects represent a risk for any
business – but if one firm invests in R&D, can a rival firm
decide not to follow? They might lose the competitive
edge in the market and suffer a long term decline in
market share and profitability.
 The dominant strategy for both firms is probably to go
ahead with R&D spending. If they do not and the other
firm does, then their profits fall and they lose market
share. However, there are only a limited number of
patents available to be won and if all of the leading firms
in a market spend heavily on R&D, this may ultimately
yield a lower total rate of return than if only one firm opts
to proceed.
The Prisoners’ Dilemma
 The classic example of game theory is the Prisoners’
Dilemma, a situation where two prisoners are being
questioned over their guilt or innocence of a crime.
 They have a simple choice, either to confess to the crime
(thereby implicating their accomplice) and accept the consequences, or to deny all involvement and
hope that their partner does likewise.
Confess or keep quiet? The Prisoner’s Dilemma is a classic example of basic game theory in action!
 The “pay-off” is measured in terms of years in prison arising from their choices and this is
summarised in the table below.
 No communication is permitted between the two suspects – in other words, each must make an
independent decision, but clearly they will take into account the likely behaviour of the other when
under-interrogation.
Nash Equilibrium
A Nash Equilibrium is an idea in game theory – it describes any situation where all of the participants in a
game are pursuing their best possible strategy given the strategies of all of the other participants.
In a Nash Equilibrium, the outcome of a game that occurs is when player A takes the best possible action
given the action of player B, and player B takes the best possible action given the action of player A
What is Game Theory? A Nobel
Prizewinner explains!
"Game Theory is the study of how
people interact when each person's
behaviour depends on, or is influenced
by, the behavior of others. It departs
from conventional applications of
economics which traditionally focus on
"consumers and producers who take
prices for granted and react to them.
In game theory, everyone's best
choice depends on what others are
going to do, whether it's going to war
or driving your car inside a traffic jam."
Thomas Schelling, Nobel Winner,
2005

97. © Tutor2u Limited 2013 97
Two prisoners are held in a separate room and
cannot communicate
They are both suspected of a crime
They can either confess or they can deny the
crime
Payoffs shown in the matrix are years in prison
from their chosen course of action
Prisoner A
Confess Deny
Prisoner B
Confess (3 years, 3 years) (1 year, 10 years)
Deny (10 years, 1 year)
(2 years, 2 years)
 What is the best strategy for each prisoner? Equilibrium happens when each player takes decisions
which maximise the outcome for them given the actions of the other player in the game.
 In our example of the Prisoners’ Dilemma, the dominant strategy for each player is to confess since
this is a course of action likely to minimise the average number of years they might expect to remain
in prison.
 But if both prisoners choose to confess, their “pay-off” i.e. 3 years each in prison is higher than if
they both choose to deny any involvement in the crime.
 In following narrowly defined self-interest, both prisoners make themselves worse off
 That said, even if both prisoners chose to deny the crime (and indeed could communicate to agree
this course of action), then each prisoner has an incentive to cheat on any agreement and confess,
thereby reducing their own spell in custody.
The equilibrium in the Prisoners’ Dilemma occurs
when each player takes the best possible action for
themselves given the action of the other player.
The dominant strategy is each prisoners’ unique best
strategy regardless of the other players’ action
Best strategy? Confess?
A bad outcome! – Both prisoners could do better by
both denying – but once collusion sets in, each
prisoner has an incentive to cheat!
Prisoner A
Confess Deny
Prisoner B
Confess (3 years, 3 years) (1 year, 10 years)
Deny (10 years, 1 year) (2 years, 2 years)

98. © Tutor2u Limited 2013 98
Applying the Prisoner’s Dilemma to Business Decisions
 Game theory examples revolve around the pay-offs that come from making different decisions.
 In the classic prisoner’s dilemma the reward to defecting is greater than mutual cooperation which
itself brings a higher reward than mutual defection which itself is better than the sucker’s pay-off.
 Critically, the reward for two players cooperating with each other is higher than the average
reward from defection and the sucker’s pay-off.
Consider this example of a simple pricing game: The values in the table refer to the profits that flow from
making a particular output decision. In this simple game, the firm can choose to produce a high or a low
output in a given time period. The profit payoff matrix is shown below.
Firm B’s output
High output Low output
Firm A’s output High output £5m, £5m £12m, £4m
Low output £4m, £12m £10m, £10m
 Display of payoffs: row first, column second e.g. if Firm A chooses a high output and Firm B opts for
a low output, Firm A wins £12m and Firm B wins £4m.
 In this game the reward to both firms choosing to limit supply and thereby keep the price relatively
high is that they each earn £10m. But choosing to defect from this strategy and increase output can
cause a rise in market supply, lower prices and lower profits - £5m each if both choose to do so.
 A dominant strategy is one that is best irrespective of the other player’s choice. In this case the
dominant strategy is competition between the firms.
 The Prisoners’ Dilemma can help to explain the breakdown of price-fixing agreements between
producers which can lead to the out-break of price wars among suppliers, the break-down of other
joint ventures between producers and also the collapse of free-trade agreements between countries
when one or more countries decides that protectionist strategies are in their own best interest.
 The key point is that game theory provides an insight into the interdependent decision-making that
lies at the heart of the interaction between businesses in a competitive market.
Potential Benefits from Collusion – A Game Theory Example
An industry consists of two firms, X and Y. The Profit-Payoff Matrix in the table below shows how the profits
of X and Y vary depending on the prices charged by the two firms
Price charged by Business B
Price Business A = £20 Price Business A = £8
Price charged by
Business A
Price Business A = £20 £12m A, £12m B £16m A, £-2m B
Price Business A = £8 £-2m A, £16m B £0m A, £0m B
If both businesses chose to collude on price rather than act competitively, the two firms would be able to
increase their joint profits by £10m. However, if they agree to collude at the higher price of £20, then there is
then an incentive for one business to under-cut the other, charge a lower price of £8 and inflicts a small loss
on the other business.

99. © Tutor2u Limited 2013 99
21. Contestable Markets
What is a Contestable Market?
 For a contestable market to exist there must be low barriers to entry and exit so that new suppliers
can come into a market to provide fresh competition.
 For a perfectly contestable market, entry into and exit out must be costless
 No market is perfectly contestable but virtually every market is contestable to some degree
even when it appears that the monopoly position of a dominant seller is unassailable.
 This can have implications for the behaviour (conduct) of existing firms and then affects the
performance of a market in terms of allocative, productive and dynamic efficiency.
 A contestable or competitive environment is common in most industries
Key Conditions for a Contestable Market
Are there Differences between Contestable Markets and Perfect Competition?
Contestable markets are different from perfect competitive markets. For example, it is feasible in a
contestable market for one firm to have price-setting power and for firms in a market to produce a
differentiated product.
There are three main conditions for pure market contestability:
o Perfect information and the ability and/or the right of all suppliers to make use of the best available
production technology in the market.
o The freedom to market / advertise and enter a market with a competing product.
o The absence of sunk costs – this reduces the risks of coming into a market.
Absenceof sunk costs Access to technology
Low consumerloyalty Size of entry barriers

100. © Tutor2u Limited 2013 100
Sunk Costs – a Barrier to Contestability
Barriers to market contestability exist when there are sunk costs i.e. costs that have been committed by a
business cannot be recovered once a firm has entered the industry.
Increasing Contestability of Markets
One feature of the British and European economy in recent years has been an increase in the number of
markets and industries that are genuinely contestable. Several factors explain this development:
1. Entrepreneurial zeal: It is often the case that markets become more competitive because of the
persistence of entrepreneurs who simply do not accept that the existing market structure is a
given. A new supplier may have the advantage of product innovation or a more competitive
business model based on different pricing strategies. A good example of this is the battle that
King of Shaves is having as the challenger brand to companies such as Gillette and Wilkinson
Sword. Metro Bank has recently opened in the UK in a bid to break the stranglehold of the existing
UK high street retail banks, retailers such as Tesco are trying to follow suit.
2. The recession – an economic downturn can have the effect of opening up markets to new
businesses. For example, the recession and subsequent slow recovery has also led to an increase
in market share for a number of discount food retailers such as Aldi and Lidl – taking away some of
the market share of the dominant food retailers.
3. De-regulation of markets – De-regulation involves the opening up of markets to competition by
reducing some of the statutory barriers to entry that exist. Good examples of recent deregulation
include the liberalisation of telecommunications and postal services as part of the European Union
competition initiatives. And also the Open Skies initiative in aviation that is aimed at opening up
trans-Atlantic air travel.
4. Competition Policy: Tougher competition laws acting against predatory behaviour by existing
firms are designed to make markets more contestable. In both the UK and the EU this has included
tougher rules against price fixing cartels.
5. The EU Single Market: The development of the Single European Market has opened up the
markets for member nations. A good example of this is home and car insurance and also the entry of
Western European clothes retailers onto the UK high streets and shopping malls.
6. Technological Change: New technology has brought down some of the entry costs in some
markets leading to an increase in capital mobility. A huge investment in open source software is
changing the contestability of the market for web browsers; there is no fierce competition between
Microsoft’s Internet Explorer, Chrome and Android (Google), Firefox (Mozilla) and Safari (Apple).
7. Technological spill-over can see the emergence of products that imitate the characteristics of the
products of the incumbent firms. Just a few years after the launch of Viagra, the anti-impotence drug,
Levitra, the first market rival to the hugely profitable Viagra, is now being manufactured by the
German firm, Bayer AG, and marketed by British firm GlaxoSmithKline. Pfizer’s patent for Viagra
expired in June 2013, allowing other pharmaceutical companies to produce their own version and
sending prices plummeting from £21.27 for a pack of four to £1.45

101. © Tutor2u Limited 2013 101
Analysis: Contestability and the Minimum Efficient Scale (MES)
The nature of costs in an industry will influence how contestable it is.
When the minimum efficient scale is a small percentage of total market demand, there is room for plenty of
businesses to reach productive efficiency in the long run and larger firms will have only a limited cost
advantage to challenger businesses. This means that the market is likely to be highly contestable.
In contrast, when there are significant economies of scale and a business can reduce their long run unit
costs by scaling up production, established businesses will have a large cost advantage and the market will
become less contestable.
Exit Costs
A barrier to exit – the costs associated with a business halting production and leaving a market - linked to the
concept of sunk costs
Cost & Price
Output (Q)
Costs and contestability in different indust
Cost & PriceLow MES, limited scale
economies, highly
contestable market
High MES, falling LRA
barriers to contes
LRAC
MES
MES will be a
small % of
market
demand
Falling LRAC acr
a very large ran
of output

102. © Tutor2u Limited 2013 102
Asset write-offs Lost consumer goodwill Redundancy costs

103. © Tutor2u Limited 2013 103
Case Study: Local monopoly in action – the
motorway service station network
Driving on the UK’s motorways is rarely a pleasant
experience as large sections of the network seem
to be permanently congested. There is, at least, the
opportunity to take a break at one of more than 100
service stations. The first service station was
opened on the M1 in 1959 at Watford Gap. The
number of service stations has almost doubled
since 1990 from 55 to 102 but has that meant the
much criticised standards have risen over the
years? There have often been accusations of high
prices and poor quality of service. Many feel that
the service stations have a captive market and
exploit this at the expense of consumers.
The UK’s motorways are served for the most part by only three providers, Moto, Roadchef and Welcome
Break – an oligopoly. These three names account for 85% of the market, the largest being Moto with 42
service stations and a turnover of £843m last year. Like many household names, although they operate as
profit centres, they are part of much larger, often overseas owned, property companies. There are smaller
operators such as First which owns two service stations, one on the M4 and another on the M61. The Tebay
Services on the northbound M6 close to the Lake District are independently owned by Westmorland Ltd.
Is there evidence of real competition between the big three players in the market? Customer inertia may
prevail. Many motorists see all service stations as much the same although there are online opportunities for
motorists to find out the good and the bad from online user sites. Therefore they may be able to fill any
information gap via the internet. The evidence is that service station operators engage in non price
competition as seen by the ‘tie-ups’ that all now have with other retail and food outlets. Moto has on its sites
Marks and Spencer’s ‘Simply Food’ and Costa Coffee. Welcome Break has Waitrose and Starbucks while
Roadchef has WH Smith and Costa Coffee. Indeed the service stations have become mini shopping malls.
New sites continue to emerge, taking advantage of the long forgotten gaps in the existing coverage of the
2,200 mile motorway network. In addition rising traffic levels mean a bigger customer base. The scope for
new stations is limited by the government as they must be at least 15 miles apart which perhaps explains the
decision by Welcome Break to start providing service stations on major roads.
There has also been a new entrant to the market, Extra MSA Services Ltd, which is part of the property
group Swayfields Ltd. This group has McDonalds on its sites which include, Beaconsfield on the M40,
Blackburn (M65) and Cullompton (M5). Their entry to the market indirectly resulted from the Competition
Commission investigation into the merger of Granada and Welcome Break in 1995. Following that
investigation the government deregulated the market making it easier for new firms to set up service
stations. This attempt to increase contestability has had limited effect on increasing competition as
Swayfields went into administration in March 2010. The new Cobham services on the M25 due to open in
2012 were being built by Extra but they may well have new owners soon. Will the incumbent firms in the
market be allowed by the competition authorities to buy Extra as it will further increase market concentration?
Set against the criticism of motorway services we have to remember they provide free parking and free
toilets. The set-up costs are high and the asset is specific to the service provided–arguably there are high
sunk costs. In any case if motorists dislike service stations so much in the last resort they can bring their own
sandwiches!
Source: Bob Nutter, EconoMax, June 2010

104. © Tutor2u Limited 2013 104
Viagra Patent Lapses – New Entrants
Poised
The drugs company Pfizer will lose its
patent protection on erectile dysfunction pill
Viagra in June 2013 – prompting dozens of
its rivals to draw up plans for their own cut-
price versions.
Use of Viagra is on the up, with 2.3 million
men in the UK prescribed the little blue pill
last year, up from 1.8m five years ago. At
the moment, a single pill costs £10 –
meaning men who are prescribed it on the
NHS are limited to just one pill a week.
Once competition is introduced, the price
will drop to just 85p, which will could well
bring about a collapse in the black market
for Viagra pills.
The end of exclusivity on the drug will be a
sore loss to Pfizer - Viagra was its sixth
best-selling drug last year, netting it
£1.35bn, up 4% on 2011. It will continue to
sell its own version, Sildenafil Pfizer, in an
attempt to cling to a share of the market.
Adapted from news reports, May 2013
Analysis: How does the threat of competition affect a firm’s behaviour?
How might the contestability of a market affect the conduct and performance of businesses? It is worth
emphasising in essays and data questions that it is the actual behaviour of agents in the market that is
more important that a simple picture of market share.
 In the diagram above a pure monopoly might price at
P1 – the profit maximising equilibrium.
 If a market is contestable, there is downward
pressure on price, because the presence
supernormal profits signals for new firms to enter the
market and if the existing monopolist is producing at
too high a price or has allowed their average total costs
to drift higher, entrants can undercut the monopolist
and some of the abnormal profit will be competed
away.
 Normal profit equilibrium occurs when average revenue
equals average total cost (at output Q2 and price P2).
A lower price and higher output causes an increase in
consumer surplus.
 When markets are contestable – we expect to see
lower profit margins than when a monopoly operates
without competition.
 The threat of competition may be just as powerful an
influence on the behaviour of the existing firms in a
market than the actual entry of new businesses
 If a market is contestable, industry structure and firm
behaviour is determined by the threat of competition -
'hit-and-run' entry. The market will resemble perfect
competition, regardless of the number of firms, since
incumbents behave as if there were intense
competition.
Costs
Revenues
Output (Q)
AC
AR (Monopoly)
MR
MC
Q1
P1
Profit Max at
Price P1
P2
Q2

105. © Tutor2u Limited 2013 105
22. Monopsony Power in Product Markets
 Monopsony is an important idea in economics but not often discussed in the media – indeed there
were only six references to it in the Financial Times between 2003 and 2009!
 But for economists wanting to understand changes in the balance of power between buyers and
sellers in different markets and how this affects prices, profit margins and incentives, it is important
to have an understanding of monopsony and its effects.
 At A2 level you will not be expected to use diagrams to show monopsony power in product markets
What is monopsony power?
1. A monopsonist has buying or bargaining power in their market.
2. This buying power means that a monopsonist can exploit their bargaining power with a supplier to
negotiate lower prices.
3. The reduced cost of purchasing inputs increases their profit margins.
4. Monopsony exists in both product and labour markets – in this chapter we focus on buying power in
the markets for goods and services.
Examples of industries where monopsony power exists and persists:
1. Electricity generators can negotiate lower prices for coal and gas supply contracts’
2. Food retailers have power when purchasing supplies from farmers, milk producers, wine growers
and other suppliers. Tesco, Sainsbury, Wal-Mart-Asda and Cooperative-Somerfield have
oligopsony power when it comes to purchasing products from businesses at earlier stages of the
supply-chain.
3. A car-rental firm seeking a contract to a manufacturer to supply new cars for their fleet
4. Low-cost airlines getting a favourable price when purchasing a new fleet of aircraft
5. British Sugar buys almost the entire sugar beet crop produced in the UK year
6. Amazon’s buying power in the retail book market – it gets a better price than other booksellers and
this gives it a significant competitive advantage.
7. The increasing buying power of countries – for example China – in securing deals to buy mineral
deposits from other countries – often in less developed nations in Africa.
8. The government is a major buyer e.g. in military procurement – and might be able to use this
bargaining power when confirming contracts for new military equipment and supplies. The National
Health Service is another example of a dominant buyer – in this case as a purchaser of prescription
drugs from the pharmaceutical companies.

106. © Tutor2u Limited 2013 106
RyanAir to buy 175 new aircraft
Low-fare airline RyanAir is to buy nearly
£10 billion-worth of new planes in a move
that will create more than 3,000 jobs. The
no-frills Irish carrier is purchasing 175 of
Boeing's new 737-800 aircraft, which will be
delivered over the period up to 2019.
The new planes will allow RyanAir to grow
its fleet to more than 400 aircraft, serving
more than 100 million passengers a year
across Europe by 2019.
Source: News reports, June 2013
Monopsony power in markets - the Groceries adjudicator checks in
A new body has been set up to police supermarket code of practice for suppliers - called the Groceries Code
Adjudicator that will sit within the Office of Fair Trading (OFT).
For many years there has been a long running saga about the buying power (monopsony power) of the
major supermarkets when purchasing from farmers. Dairy producers have complained that the supermarkets
have squeezed prices to such an extent that they can no longer make money - many have left the industry.
The supermarkets respond that many of the complaints come from lobby groups that have no day-to-day
experience of the farming/retail relationship. They claim it is simply not in their own interest for commercial
relationships with the farmers to threaten the economic viability of the farming industry. The long running row
over whether supermarkets abuse their dominant relationship with some farmers and food suppliers will
rumble on.
Jim Paice - UK farming minister argues that “The new adjudicator will help to strike the right balance
between farmers and food producers getting a fair deal and supermarkets ensuring their customers can get
the high- quality British food they want at a price they can afford.” Critics argue that the new body is not
needed and it will become another costly quango and a cause of government failure.
Source: Tutor2u economics blog, August 2010
In evaluation it is important to remember some of the possible advantages from monopsony power:
1. Improved value for money – for example the UK
national health service can use its bargaining power to
drive down the prices of routine drugs used in NHS
treatments and ultimately this means that cost savings
allow for more treatments within the NHS budget.
2. Producer surplus has a value as well as consumer
surplus – lower input costs will raise profitability that
might be used to fund capital investment and research.
3. A monopsonist can act as a useful counter-weight to the
selling power of a monopolist e.g. the NHS versus the
global pharmaceutical companies.
4. In most supply chain relationships – for example
between supermarkets and their suppliers – the long
term sustainability of an industry requires that both
benefit – if there are no mutually beneficial gains from
trade, ultimately trade and exchange will break down.
5. The growth of the Fair Trade label and organisation is
evidence of how pressure from consumers can lead to
improved contracts and prices for farmers in developing countries. For example if tea producers in
Rwanda get a stronger price for their output, the increased income and profit will have important
economic and social benefits for the exporting industry and the wider economy.

107. © Tutor2u Limited 2013 107
Case Study: Milk prices,
monopsony power and the future
for milk farming in the UK
Hats off to the herd! Milk production in
the UK is expanding yet many dairy
farmers have or are likely to leave the
industry over the next five years unless
raw milk production becomes more
economically viable. Can the
stakeholders in the sector reach fresh
agreement on sustainable contracts for
the near 40 million litres of milk
produced every day?
Milk is just about the most regular
purchase that we make in the shops
and supermarkets. The nation
consumes over 5 billion litres of milk
every year, but few of us stop to check
the price as our cartons drop straight into the basket. 53% of the milk that produce in the UK is sold as liquid
milk. The other 47% goes into cheese, butter, yoghurts and a variety of other dairy products.
At the other end of the supply-chain, the price that dairy farmers get for their milk is absolutely crucial,
indeed unless the return that milk producers get improves in the near future; many more farmers seem set to
leave the industry unable to sustain mounting losses. Those that remain will be unable to generate sufficient
profit to finance re-investment in breeding stock, new buildings and farm machinery. Low levels of
investment will hit productivity in the future and may also affect animal welfare - healthy cows need good
facilities and farmers need a profitable price.
The National Farmers Union (NFU) has estimated that dairy farmers in Britain are losing upwards of £300
million a year as supply costs increase and lag behind the farm-gate price paid to farmers by the major milk
processing and distribution businesses such as Robert Wiseman, Arla Foods and Dairy Crest. These
processors have oligopsony power in the market in other words; they have significant purchasing power
when buying from producers at an earlier stage of the supply chain. The main alternative is either for farmers
to join a cooperative - in the UK Milk Link and First Milk has roughly 10% to 11% of the market apiece - or to
sell their milk direct to local and national supermarkets or direct to customers through farm shops.
Whilst it is vital for the dairies to establish and build strong supply relationships with dairy farmers, for many
years there has been concern that the giant milk processors have used their buying-power (economists call
this monopsony) to keep farm gate prices lower than they might otherwise be. The NFU's data finds that the
average cost of milk production is currently 29.1 pence per litre (ppl). With an average British milk price of
25.94ppl, this result in a 3.16ppl gap between the cost of producing milk and the price the farmer receives.
Dairy producers have had to cope with a surge in their operating costs over the last few years. For example,
average feed wheat prices are 66.7% higher than a year ago; the average price of fertiliser is 19.4% higher
than at the same time last year and ammonia Nitrate bag prices are 34.2% higher than in May 2010. Feed
wheat prices alone are said to contribute around 20% of the unit cost of each litre of milk supplied. Average
income from dairy farms in 2009-10 was more than £24,000 before any income from EU farm support
payments but for many that income is insufficient to reap a profit.
Faced with persistent losses, many farmers have closed down and leave for pastures new. UK dairy cow
numbers have declined by 10,000 in the last year alone, in the UK there are now 1.85 million dairy cows in
the dairy herd and this has shrunk by seven per cent over the last five years.
Back in the supermarket aisles, Sainsbury's, Waitrose and Tesco charged £1.49 for 4 pints in June 2011 with
Asda charging £1.25 for 4 pints. 4 pints converts to 2.27 litres. A quick calculation tells us that farmers are
getting an average of 59 pence for supplying 4 pints but the retail price in most supermarkets is 90 pence
higher.
Most milk supply contracts require farmers based in Britain to sell all their milk to one of the major buyers for
no less than 12 months and without any certainty of the base price they would receive. Milk processors then
supply mainly to the supermarkets.

108. © Tutor2u Limited 2013 108
The Farmers' Union is lobbying for a revised system of milk supply contracts what ensure milk supply deals
bring greater fairness to relationships between milk producers and processors. This campaign has gathered
momentum in the last two years partly because of steeply rising costs for many farmers (notably the soaring
cost of livestock feed) and also because of the failure of Dairy Farmers of Britain, a milk producer
cooperative which was responsible for 10% of UK milk production and which collapsed in 2009 leaving many
farmers desperately searching for buyers of their produce.
Without a higher farm gate (or wholesale) price the probability is that a growing number of farmers will opt to
leave the sector. Some have attempted to diversify into higher value-added products such as yoghurts, ice-
creams and cheese and there are some notable successes especially when niche brands that can sustain
premium prices have emerged. Low profitability is also incentivising a longer term switch towards large-scale
intensive milk production which smaller dairy farmers giving way to huge dairy complexes capable of
supplying many millions of
Enlightened food retailers are also seeking to reach deeper agreements with farmers for example the ‘Milk
Pledge Plus’ payment scheme set up by Marks and Spencer a milk payment scheme that adjusts for
changing costs of supply and which also offers rewards for dairy farmers who meet very high animal health
and welfare standards. Show-casing local sourcing of milk which meets strict environmental standards is
often a profitable marketing strategy for the supermarkets and provides greater certainty about revenue
streams for the farmers themselves.
But the vast bulk of milk produced in the UK will continue to flow through the processing industries and then
to the supermarkets. In Britain we have not made enough progress in resolving the disputes between
farmers, suppliers and supermarkets and a solution remains unlikely because of the imbalance in bargaining
power between farmers and processors. Put simply there remains a huge, structural price differential
between what dairy farmers get at their gate and what the consumer pays at the supermarket. This
monopsony power is a market failure that has cost many jobs, cut agricultural investment and made the UK
more dependent on milk imports.

109. © Tutor2u Limited 2013 109
Case Study: The Care Home Crisis
Over the next 25 years the number of over 85s
in the UK will double and many in this age
group will need care either in specialist homes
or in their own home. The increased numbers of
elderly people will mean another 18,000 needing
care home places compared to today. However, if
recent trends continue the number of care home
beds will fall by 81,000 by 2020. In 2010 5,190
care home beds were lost and according to a
recent report commissioned by BUPA, the health
insurance and care provider, this could rise to 8,500
per year by 2015
Local authorities (mainly county councils) administer adult social care and they
purchase beds in care homes on behalf of elderly clients in their jurisdiction. The care home fees are paid
by the local authority if clients have low savings, but those with higher savings or with assets such as a
house, pay some or all of the fees to the care home. The means-tested fees system means that the better-
off have to pay all of the fees themselves and often have to sell their home to do so. They are said to be ‘self
funding’.
It seems a little odd that the number of care home beds is going down when the elderly population is
increasing. Indeed in January 2011 there were 4,640 delayed discharges of elderly people from NHS
hospitals because appropriate care for them could not be arranged. Most of the elderly would like to stay in
their own home as long as possible and local authorities support their wishes. Hence, part of the crisis of
NHS beds being blocked by the elderly, is the time it takes to arrange what are called packages of care for
patients discharged from hospital into their own homes.
It is fair to say that some of the losses in care beds are accounted for by the closure of residential homes
resulting from the increased numbers of elderly people continuing to live at home for as long as possible.
However, the decline in the number of care home beds is not explained simply by the growth in care
provision at home. The fact is making a profit in the privately-owned care home sector has become
increasingly difficult in recent years. Although there are large companies in this sector such as Southern
Cross and BUPA Care Homes, who are capable of gaining significant economies of scale, even they have
struggled. The problem in part is the buying-power of local authorities who buy about 60% of beds in care
homes on behalf of their clients. This means that they fix the fees rather than the homes themselves, and
care home owners would argue that the fees are not high enough to make a profit.
Economists would see the driving down of fees as an abuse of something akin to monopsony power by
local authorities. A monopsonist is a sole buyer and thus it has huge advantages over the seller. Last
April, many local authorities froze the weekly fee per bed leaving care homes with a shortfall/loss on every
local authority funded bed of around £90, with £700 the approximate weekly cost per bed. This buying power
cannot be explained as an economy of scale where the care homes offer the local authorities discounts for
block booking. It seems to be a case of local authorities saying these are our fees -take it or leave it.
Local authorities claim that they have insufficient money to pay any more than they do, although they have
recently been given an extra £2bn for adult social care by the central government. However, this money is
not ring fenced for care home provision. How do the care homes survive in this situation? Some care homes
charge more for self funding clients than they receive for local authority funded clients which in itself is
probably anti-competitive and an example of price discrimination. The possibility of 100,000 elderly people
occupying the 170,000 NHS hospital beds in a few years’ time is a possibility, if current trends continue.
There will simply not be enough care home places to put them when ready for discharge from the NHS
hospitals where many are initially admitted. Many would argue that the elderly care problem is too large for
the local authorities to handle and that a national care service for the elderly needs to be set up to deal with
this complex issue. At the moment it appears to be a ticking time bomb with a slow burning fuse.
Source: Robert Nutter, EconoMax, Easter 2011

110. © Tutor2u Limited 2013 110
23. Consumer and Producer Surplus
Consumer and producer surplus explained
 Consumer surplus is the difference between the total amount that consumers are willing and able
to pay for a good or service (indicated by the demand curve) and the total amount that they actually
pay (the market price).
 Producer surplus is the difference between what producers are willing and able to supply a good
for and the price they actually receive. The level of producer surplus is shown by the area above the
supply curve and below the market price.
Economic efficiency
Economic efficiency is achieved when an output of goods and services is produced making the most efficient
use of our scarce resources and when that output best meets the needs and wants and consumers and is
priced at a price that fairly reflects the value of resources used up in production.
1. If in an economy, no one can be made better off without making someone else worse off, the
conditions for allocative efficiency have been met.
2. If in an economy, production of goods and services takes place at minimum of feasible average cost,
the conditions for productive efficiency have been met.
Price
Quantity
Demand
Supply
P1
Q1
Equilibrium Point
Consumer
Surplus
Producer Surplus

111. © Tutor2u Limited 2013 111
Price discrimination and consumer & producer surplus
Price discrimination occurs when a firm charges a different price to different groups of consumers for an
identical good or service, for reasons not associated with the costs of supply.
With 1st
degree price discrimination the firm is able to perfectly segment the market so that the
consumer surplus is removed and turned into producer surplus. Thus there is a clear transfer of welfare from
consumers to producers.
Third degree (or multi-market) price discrimination involves charging different prices for the same product in
different segments of the market. Price elasticity of demand is the key factor determining the pricing decision
for producers for each part of the market.
Costs
Revenues
Output (Q)
Market Demand
Supply in a competitive market
P1
Q1
Consumer
Surplus (CS)
Producer
Surplus (PS)
P2
Q2
Net Loss of Economic
Welfare from price P2 raised
above the equilibrium price
Allocative efficiency in a competitive market
At the competitive market equilibrium price and output, we maximise consumer and producer
surplus. No one can be made better off without making someone else worse off – this is known as
the condition required for a Pareto optimal allocation of resources
Allocative efficient price
and output at the market
equilibrium
Requires other markets to

112. © Tutor2u Limited 2013 112
The market is usually separated in two ways: by time or by geography. For example, exporters may charge a
higher price in overseas markets if demand is found to be more inelastic than it is in home markets. There is
more consumer surplus to be exploited when demand is insensitive to price changes.
Quantity of Output (Q)
Price (P)
AR (Market Demand)
MR
P1
Average Cost = Marginal Cost
Q1
P2
P4
Q3Q2
Equilibrium output with perfect price
discrimination – the monopolist will sell an
extra unit providing that the next unit adds
as much to revenue as it does to cost
P3
P5
Q4 Q5
Consumer surplus is turned into
extra revenue for the producer
= additional producer surplus
(higher profits)
Market A
Market B
MC=AC
QuantityQuantity
Price Price
Pa
Pb
MRa
MRb ARb
ARa
Profit from selling to market A
– with a relatively elastic
demand – and charging a
lower price
Demand in segment B of the
market is relatively inelastic. A
higher unit price is charged
MC=AC
QbQa
Consumer surplus at Price Pa Consumer surplus at Price Pa

113. © Tutor2u Limited 2013 113
24. Summary on Market Structures
Differences in Profitability between Industries
Summary on Market Structures
Market structure is best defined as the organisational and other characteristics of a market. We focus on
those characteristics which affect the nature of competition and pricing – but it is important not to place too
much emphasis simply on the market share of the existing firms in an industry.
Traditionally, the most important features of market structure are:
 The number of firms (including the scale and extent of foreign competition)
 The market share of the largest firms (measured by the concentration ratio – see below)
 The nature of costs (including the potential for firms to exploit economies of scale and also the
presence of sunk costs which affects market contestability in the long term)
 The degree to which the industry is vertically integrated - vertical integration explains the
process by which different stages in production and distribution of a product are under the ownership
and control of a single enterprise. A good example of vertical integration is the oil industry, where the
major oil companies own the rights to extract from oilfields, they run a fleet of tankers, operate
refineries and have control of sales at their own filling stations.
 The extent of product differentiation (which affects cross-price elasticity of demand)
 The structure of buyers in the industry (including the possibility of monopsony power)
 The turnover of customers (sometimes known as “market churn”) – i.e. how many customers are
prepared to switch their supplier over a given time period when market conditions change. The rate
of customer churn is affected by the degree of consumer or brand loyalty and the influence of
persuasive advertising and marketing
Key reasons why industry profits vary
Low industry profits as
Strong suppliers
Strong customers (buye
Low entry barriers
Many opportunities for
Intense rivalry between
High industry profits associated with:
Weak suppliers
Weak customers (buyers)
High entry barriers
Few opportunities for substitutes
Little rivalry between competitors
E.g. soft-drinks (dominated by Coca-Cola &
Pepsi
E.g. airline industry (world
of over $2bn per year

114. © Tutor2u Limited 2013 114

115. © Tutor2u Limited 2013 115
Characteristic Perfect
Competition
Oligopoly Monopoly Contestable Market
Number of firms Many Few dominant
firms
One with pure
monopoly
Effective duopoly in
many cases
Many
Type of product Homogenous Differentiated Limited Differentiated
Barriers to entry None High High Low entry and exit
costs
Supernormal short run
profit
   Any profit possible
Supernormal long run
profit
   Supernormal invites
hit and run entry
Pricing power Price taker
(passive)
Price maker but
interdependent
behaviour
Price maker –
constrained by
demand curve and
possible regulation
Price maker – but
actual and potential
competition limits
pricing power
Non price competition   (important)   (important)
Economic efficiency High Low allocative
but scale
economies and
innovation
Low allocative but
economies of scale
and reinvested
profits
Risk of X-
inefficiency due to
lack of competition
High – depending
on strength of
contestability
Innovative behaviour Weak Very Strong Potentially strong Strong
Market structure and innovation
Which market conditions are optimal for effective and sustained innovation to occur? This is a question that
has vexed economists and business academics for many years.
High levels of research and development spending are frequently observed in oligopolistic markets,
although this does not always translate itself into a fast pace of innovation.
The recent work of William Baumol (2002) provides support for oligopoly as market structure best suited for
innovative behaviour. Innovation is perceived as being “mandatory” for businesses that need to establish a
cost-advantage or a significant lead in product quality over their rivals.
“As soon as quality competition and sales effort are admitted into the sacred precincts of theory, the price
variable is ousted from its dominant position…But in capitalist reality as distinguished from its textbook
picture, it is not that kind of competition which counts but the competition which commands a decisive cost or
quality advantage and which strikes not at the margins of profits and the outputs of the existing firms but at
their foundations and their very lives. This kind of competition is as much more effective than the other as a
bombardment is in comparison with forcing a door”
Supernormal profits persist in the long run in an oligopoly and these can be used to finance research and
development.

116. © Tutor2u Limited 2013 116
25. Government Intervention –
Competition Policy
What are the key aims of competition policy?
The aim of competition policy is promote competition;
make markets work better and contribute towards
improved efficiency in individual markets and enhanced
competitiveness of UK businesses within the European
Union single market.
Competition policy aims to ensure
o Technological innovation which promotes dynamic
efficiency in different markets
o Effective price competition between suppliers
o Safeguard and promote the interests of consumers
through increased choice and lower price levels
There are four key pillars of competition policy in the UK
and in the European Union
1. Antitrust & cartels: This involves the elimination of
agreements that restrict competition including price-
fixing and other abuses by firms who hold a
dominant market position (defined as having a
market share in excess of forty per cent)
2. Market liberalisation: Liberalisation involves
introducing fresh competition in previously
monopolistic sectors such as energy supply, postal
services, mobile telecommunications and air
transport
3. State aid control: Competition policy analyses
examples of state aid measures to ensure that such
measures do not distort competition in the Single
Market
4. Merger control: This involves the investigation of
mergers and take-overs between firms (e.g. a
merger between two large groups which would result
in their dominating the market)
Main Roles of the Regulators
 Regulators are the rule-enforcers and they are
appointed by the government to oversee how a
market works and the outcomes that result for
producers and consumers
 Examples of regulators include the Office of Fair
Trading and the Competition Commission
 The European Union Competition Commission is
also an important body for the UK
Pay Day Loans Industry to be
investigated by Competition
Commission
A downside of the prolonged downturn in
the UK in recent years has been the rise of
the pay day loan companies, particularly
in locations that suffer from relatively low
incomes and higher unemployment. In
most countries, pay day lending is
banned, but not in the UK where financial
services of this kind are largely
deregulated. Unlike standard secured or
unsecured loans, payday loans are short-
term borrowing solutions aimed at those
facing immediate financial difficulty
The Competition Commission is to launch
a full-scale inquiry into the operation of
payday loan companies. In the past three
years, the payday loan industry has
expanded rapidly from £90m to around
£2.2bn - a reflection of the increasing
financialisation of the British economy.
The review will take over a year to
complete and a range of actions are
possible including caps on the sky-high
interest rates that are charged on loans.
Average loan interest rates charged by
Wonga, the UK’s largest payday lender,
are now 5,853 per cent (annual
percentage rate). The average payday
loan issued in 2012 was for an amount
between £265 and £270 over 30 days
The payday market is relatively
concentrated, with three companies
accounting for 55 per cent of the market
by turnover and 57 per cent by value of
loans. This industry would be
characterised as an oligopoly.

117. © Tutor2u Limited 2013 117
What do the regulators do in their respective markets?
1. Monitoring and regulating prices: Regulators aim to ensure that companies do not exploit
their monopoly power by charging excessive prices. They look at evidence of pricing behaviour
and also the rates of return on capital employed to see if there is evidence of ‘profiteering.’
Recently the EU Competition Commission has enforced a number of cuts in the charges that
can be made by mobile phone businesses when customers travel overseas.
2. Standards of customer service: Companies that fail to meet specified service standards can
be fined or have their franchise / license taken away. The regulator may also require that
unprofitable services are maintained in the wider public interest e.g. BT keeping phone booths
open in rural areas and inner cities; the Royal Mail is still required by law to provide a uniform
delivery service at least once a day to all postal addresses in the UK
3. Opening up markets: The aim here is to encourage competition by removing or lowering
barriers to entry. This might be achieved by forcing the dominant firm in the industry to allow
others to use its infrastructure network. A key task for the regulator is to fix a fair access price for
firms wanting to use the existing infrastructure. Fair both to the existing firms and also potential
challengers. A good example to use here is the attempt in the UK to introduce more competition
into the banking industry by encouraging the entry of challenger banks to compete against the
large established commercial banking businesses.
4. The “Surrogate Competitor”: Regulation can act as a form of surrogate competition –
attempting to ensure that prices, profits and service quality are similar to what could be achieved
in competitive markets. Fear of action by OFT and other regulators may prevent anticompetitive
behaviour (i.e. there will be a deterrent effect)
Protecting the public interest
The key role of competition authorities around the world including the European Union is to protect the
public interest, particularly against firms abusing their dominant positions
A firm holds a dominant position if its power enables it to operate within the market without taking account of
the reaction of its competitors or of intermediate or final consumers.
Anti-Trust Policy - Abuses of a Dominant Market Position
 A firm holds a dominant position if its power enables it to operate within the market without taking
account of the reaction of its competitors or of intermediate or final consumers.
 Competition authorities consider a firm’s market share, whether there are credible competitors,
whether the business has ownership and control of its own distribution network (achieved
through vertical integration) and whether it has favourable access to raw materials.
 Holding a dominant position is not wrong if it is the result of the firm's own competitiveness But if the
firm exploits this power to stifle competition, this is an anti-competitive practice.
Anti-competitive practices are designed to limit the degree of competition inside a market.
Examples of anti-competitive practices
1. Predatory pricing also known as ‘destroyer pricing’ happens when one or more firms deliberately
sets prices below average cost to incur losses for a sufficiently long period of time to eliminate or
deter entry by a competitor – and then tries to recoup the losses by raising prices above the level
that would ordinarily exist in a competitive market.
2. Vertical restraint in the market: This can happen in a number of ways:
a. Exclusive dealing: This occurs when a retailer undertakes to sell only one manufacturers
product. These may be supported with long-term contracts that “lock-in” a retailer to a
supplier and can only be terminated by the retailer at high financial cost. Distribution
agreements may seek to prevent instances of parallel trade between EU countries (e.g.
from lower-priced to higher priced countries).

118. © Tutor2u Limited 2013 118
b. Territorial exclusivity: This exists when a particular retailer is given the sole rights to sell
the products of a manufacturer in a specified area.
c. Quantity discounts: Where retailers receive larger price discounts the more of a given
manufacturer's product they sell - this gives them an incentive to push one manufacturer's
products at the expense of another's.
d. A refusal to supply: Where a retailer is forced to stock the complete range of a
manufacturer's products or else he receives none at all, or where supply may be delayed to
the disadvantage of a retailer.
3. Collusive practices: These might include agreements on market sharing, price-fixing and
agreements on the types of goods to be produced.
Price Fixing and the Law
UK competition law prohibits almost any attempt to fix prices - for example, you cannot
o Agree prices with competitors or agree to share markets or limit production to raise prices.
o Impose minimum prices on different distributors such as shops.
o Agree with your competitors what purchase price you will offer your suppliers.
o Cut prices below cost in order to force a weaker competitor out of the market.
o Under the Competition Act 1998 and Article 81 of the EU Treaty, cartels are prohibited. Any
business found to be a member of a cartel can be fined up to 10 per cent of its worldwide
turnover. In addition, the Enterprise Act 2002 makes it a criminal offence for individuals to
dishonestly take part in the most serious types of cartels. Anyone convicted of the offence
could receive a maximum of five years imprisonment and/or an unlimited fine.
Legal Collusion – Horizontal Cooperation
Not all instances of collusive behaviour are deemed to
be illegal by the European Union Competition
Authorities. Practices are not prohibited if the respective
agreements "contribute to improving the production or
distribution of goods or to promoting technical progress
in a market.”
 Development of improved industry standards
of production and safety which benefit the
consumer – a good recent example is joint
industry standards in Europe for mobile phone
chargers
 Information sharing designed to give better
information to consumers
 Research joint-ventures and know-how
agreements which seek to promote innovative
and inventive behaviour in a market. The EU
has introduced a “R&D Block Exemption
Regulation” for this
Market Liberalisation
 The main principle of EU Competition Policy is
that consumer welfare is best served by
introducing competition in markets where
monopoly exists.
 Frequently, these monopolies have been in network industries such as transport, energy and
telecommunications.
Horizontal Cooperation: Joint Research
Project launched to tackle MRSA
GlaxoSmithKline and AstraZeneca have
won Euro200 million of funding from the
European Commission to fund a joint
research project seeking to find a new class
of antibiotics. The bid comes as evidence
grows of the huge financial and social cost
from over 25,000 annual deaths in Europe
from superbugs acquired in hospital.
Traditionally antibiotics make low profits for
pharmaceutical businesses as they are
rationed by doctors and hospitals to avoid a
buildup of resistance and patients are given
a course of treatment for their infections.

119. © Tutor2u Limited 2013 119
 In these sectors, a distinction must be made between the infrastructure and the services provided
directly to consumers using this infrastructure.
While it is often difficult to establish a second, competing infrastructure, for reasons linked to investment
costs and efficiency (i.e. the natural monopoly arguments linked to economies of scale and a high
minimum efficient scale) it is possible and desirable to create competitive conditions in respect of the
services provided.
Case Study: OFT report finds welfare gains from liberalising pharmacies
The OFT has produced a new report looking at some of the welfare and efficiency effects of the decision to
liberalise the retail pharmacy industry in the UK. The report finds that “Partial liberalisation of the pharmacies
market has brought significant benefits for consumers, including shorter waiting times; a greater choice of
pharmacies and extended opening hours....the number of pharmacies operating in England has risen by
nearly nine percent. Fears that enabling easier entry would lead to large numbers closing have so far proven
unfounded.”
The wider availability of supermarket pharmacies on spending by consumers on over-the-counter medicines
has led to conservatively estimated annual savings of around £5m. In the UK retailers have been free to set
their own price since resale price maintenance (RPM) on branded OTCs such as pain killers and flu relief
tablets was abolished in 2001. The largest share of any one company is now that of Boots (18.3 per cent),
following the merger with Alliance Unichem (owner of Moss Pharmacies) to form Alliance Boots in 2006. In-
store supermarket pharmacies – account for almost 7 per cent of the total.
Source: Tutor2u economics blog, March 2010
State Aid in Markets
The argument for monitoring state aid given to private and state businesses by member Government is that
by giving certain firms or products favoured treatment to the detriment of other firms or products, state aid
disrupts normal competitive forces.
Under current European state aid rules, a company can be rescued once. However, any restructuring aid
offered by a national government must be approved as being part of a feasible and coherent plan to restore
the firm’s long-term viability. Government aid designed to boost research and development, regional
economic development and the promotion of small businesses is normally permitted.

120. © Tutor2u Limited 2013 120
Merger Policy in the UK and the European Union
Corporate restructuring is a fact of life. There is a natural tendency for markets to consolidate over take
through a process of horizontal and vertical integration. The main issue for competition policy is whether a
proposed merger or takeover between two businesses is thought to lead to a substantial lessening of
competitive pressures in the market and risks leading to a level of market concentration when collusive
behaviour might become a reality.
When companies combine via a merger, an acquisition or the creation of a joint venture, this generally has a
positive impact on markets: firms usually become more efficient, competition intensifies and the final
consumer will benefit from higher-quality goods at fairer prices.
However, mergers which create or strengthen a dominant market position can, after investigation, be
prohibited in order to prevent ensuing abuses. Acquiring a dominant position by buying out competitors is in
contravention of EU competition law. Companies are usually able to address the competition problems,
normally by offering to divest (sell or off-load) part of their businesses. For example, in 2007, the UK
Competition Commission decided that Sky would be forced to sell some of its 17.9% stake in ITV.
Case Study: EU Imposes Price Caps on Mobile Calls
For several years the European Union Competition Commission has been targeting the oligopolistic mobile
phone industry accusing it of damaging consumer welfare with high roaming charges when people are
travelling and working within Europe. The cost of using mobile phones when travelling within Europe will be
reduced from July 2012 after cuts to roaming costs were agreed by European Union policy makers.
As a result of direct price intervention, the cost of data services on smart phones within the EU single market
will be capped at €0.70 a megabyte, far less than most carriers in the EU currently charge. Prices on voice
calls will also be capped, falling from €0.35 to €0.29 in July and €0.19 in 2014. Text message prices will fall
from €0.11 to €0.06.
The EU plans further structural reforms to the telecoms market hoping that more competition will bring down
prices and stimulate an increase in dynamic efficiency in the industry. Lower charges for telecoms will have
positive spill over effects for millions of consumers and industries whose telecommunications costs will fall.
From 2014, mobile phone customers will be able to sign up with one company for domestic calls and another
for their overseas trips, while retaining the same number. The hope is that new telecoms firms will want to
come into the market and make it more contestable. The industry is dominated by France Telecom (Orange),
Deutsche Telekom (T-Mobile), Spain’s Telefónica (O2) and the UK's Vodafone.
The leading mobile phone operators claim that price capping by the EU will force them to find other ways of
generating revenue for example by hiking up the prices of handsets which are often sold as a loss-leader to
get people to commit to a mobile network. Some analysts say that lower prices and profits will cause a
reduction in capital investment in networks especially at a time when businesses such as Vodafone are
planning to spending billions for the spectrum needed to deliver superfast mobile broadband.
Source: Tutor2u Economics Blog, March 2012
Microsoft hit with new EU fine
Microsoft has been fined £485m by the European Competition Commission fine after an update to the
Windows operating system meant it broke a legally-binding commitment to offer consumers a choice of web
browser. In 2009 it agreed to offer Windows buyers a choice of alternatives such as Google’s Chrome,
Mozilla Firefox and Apple Safari when they first booted up their new operating system. As the web has
expanded in recent years, Microsoft’s influence over it has weakened.
At the beginning of 2009 Internet Explorer dominated with an almost two-thirds share of the global market, In
March 2013, Internet Explorer accounted for only a quarter of visits to websites, with Google’s Chrome the
main beneficiary. It was first introduced in late 2008 and is now the world’s most popular browser, heavily
promoted on the Google homepage, with a third of the market. Rival giants such as Google, Facebook and
Apple are now seen as the main forces of web business, particularly as traffic increasingly shifts from
desktop and laptop computers to smart phones and tablets.
Source: Adapted from news report, March 2013

121. © Tutor2u Limited 2013 121
Case Study: Investigation into competition
in the UK Retail Fuel Industry
A report from the Office of Fair Trading has
investigated competition in the UK road fuel
sector. UK consumers have seen a 38 per cent
increase in the price of petrol and a 43 per cent
increase in diesel costs between 2007 and 2012.
Some groups have claimed that tacit collusion
between petrol retailers has been a factor behind
this rise in price and the slowness of prices to fall
when world crude oil prices decline.
But the OFT report has found that increases in
pump prices for petrol and diesel over the last 10
years have been caused largely by higher crude
oil prices and increases in tax and duty and not a
lack of competition.
The market for petrol and diesel is worth more than £45 billion each year with road fuels making up 4.5 per
cent of average UK households’ weekly spending
The OFT found that, pre-tax, the UK has some of the cheapest road fuel prices in Europe. In the 10 years
between 2003 and 2012 pump prices increased from 76 pence per litre (ppl) to 136ppl for petrol, and from
78ppl to 142ppl for diesel, caused largely by an increase of nearly 24ppl in tax and duty and 33ppl in the cost
of crude oil.
A key feature of the road fuels sector over
the past decade has been the growing
influence of the big four supermarkets.
They increased their share of road fuel
sold in the UK from 29 per cent in 2004 to
39 per cent in 2012. The supermarkets'
high throughput per forecourt and greater
buying power has allowed them to sell
fuel more cheaply than other competitors.
In August 2012, for example, the average
price of petrol at supermarkets was 2ppl
cheaper than the average at oil company-
owned sites and 4.3ppl cheaper than the
average charged by independent dealers.
Controlling for all other factors, the
presence of at least one supermarket in a
local area is associated with pump prices
that are 0.5ppl lower for diesel and 0.7ppl
lower for petrol, compared to an area with
no supermarket fuel retailing presence
The OFT recognises that many smaller independent dealers have found it difficult to compete in this sector,
with a significant number exiting the market. Overall, the number of UK forecourts has fallen from 10,867 in
2004 to 8,677 in 2012,
The report into the market did find sizeable differences in pump prices between neighbouring towns - petrol
and diesel tend to be cheaper in local areas that have a greater number of local retailers, in particular areas
where there are supermarket forecourts.
Petrol was around 1.9ppl more expensive and diesel around 1.7ppl more expensive in rural areas than in
urban areas. The report also found that fuel is often significantly more expensive at motorway service
stations. In August 2012, for example, prices were on average 7.5ppl higher for petrol and 8.3ppl higher for
diesel than at other UK forecourts.

122. © Tutor2u Limited 2013 122
26. Government Intervention – Price Regulation
Utility regulators
Former state-owned utilities are regulated to ensure that they do not exploit their monopoly position. In the
long run, the thrust of regulation has been to encourage competition by easing the entry of new suppliers
and making markets more contestable.
 Ofwat – (water services regulation authority) – Ofwat is the body responsible for economic
regulation of the privatised water and sewerage industry in England and Wales. Key issues for Ofwat
at the moment include the threats of water shortages, the problems of leaks and rising water bills.
 Financial Services Authority – oversees banking and other financial industries, heavily criticised for
its role in allowing excessive lending and risk taking by the banks which ultimately led to the global
credit crisis and subsequent recession.
 Ofcom - The Office of Communications is the UK's communications regulator
 Ofgem - The Office of Gas and Electricity Markets is the government regulator for the electricity and
downstream natural gas markets in Great Britain. Its primary duty is to “promote choice and value for
all gas and electricity customers".
 Office of the Rail Regulator – ORR is the UK government's agency for regulation of the country's
railway network.

123. © Tutor2u Limited 2013 123
Price Regulation for the Utilities
Regulation of prices through price capping has been a feature of regulation of the utilities in the UK for many
years – although this is now being phased out as most utility markets have become more competitive.
Price capping systems
 Price capping is an alternative to rate-of-return regulation, in which utility businesses are allowed to
achieve a given rate of return (or rate of profit) on capital.
 In the UK, price capping has been known as "RPI-X". This takes the rate of inflation, measured by
the Consumer Price Index and subtracts expected efficiency savings X. So for example, if inflation is
5% and X is 3% then an industry can raise their prices on average by only 2% per year
 In the water industry, the formula is "RPI - X + K", where K is based on capital investment
requirements designed to improve water quality and meet EU water quality standards. This has
meant increases in the real cost of water bills for millions of households in the UK.
Advantages
o Capping is an appropriate way to curtail the monopoly power of “natural monopolies” – preventing
them from making excessive profits at the expense of consumers
o Cuts in the real price levels are good for household and industrial consumers (leading to an
increase in consumer surplus and higher real living standards in the long run).
o Price capping helps to stimulate improvements in productive efficiency because lower costs are
needed to increase a producer’s profits.
o The price capping system is a tool for controlling consumer price inflation in the UK.
Disadvantages
o Price caps have led to large numbers of job losses in the utility industries
o Setting different price capping regimes for each industry distorts the price mechanism
Current arrangements for price capping in the UK
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 Ongoing – 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

124. © Tutor2u Limited 2013 124
Case Study: Regulated and Unregulated Rail Fares
For millions of regular rail users, the fare system in
operation in the UK is almost impossible to understand!
Annual changes in a complex system of rail fares bring
about anger and hostility and there are regular claims that
the increasing cost of travelling by rail is a disincentive to
use the train instead of the car. The current system of rail
fare regulations is as follows:
 Around 45 per cent of fares are subject to
regulation – these are season tickets for most
commuter journeys and off-peak fares on most
intercity journeys. The rest are set by the train
operating companies themselves
 Since January 2004, annual rises in regulated fares have been limited to RPI+1 per cent. The RPI
rate for July in each year is taken as the benchmark for the next set of fare changes
 The price capping regime for rail is RPI + 3% - for three years from January 2012
 Thus, from January 2013 fares are anticipated to rise by 6.2 per cent, based on a July 2012 RPI of
3.2 per cent and an increase in the regulated fares cap to RPI+3
 The main justification for the change in the pricing regime was that “the Government can deliver
priority capacity improvements on the rail network to relieve overcrowding and improve passenger
comfort.” The government is also keen to cut the general subsidy paid to rail companies.
 Unregulated fares are determined by the train operating companies – i.e. the businesses that have a
franchise to operate a particular service using the infrastructure maintained by Network Rail.
Operating costs for running services are high, profit margins for the operators have remained stable
and relatively low since the privatisation of the railways – the average return is between 3 and 4%
 The chart below shows how the index of passenger rail fares has outstripped the consumer price
index – partly because of the built-in fare rises caused by the price regulation system
Index of consumer prices (all items) and passenger rail fares, 2005=100
The Rising Cost of Rail Fares
All items (CPI) Passenger transport by railway
Source: Reuters EcoWin
05 06 07 08 09 10 11 12
95
100
105
110
115
120
125
130
135
140
145
150
Index
95
100
105
110
115
120
125
130
135
140
145
150
Consumer Price Index (all items)
Passenger Rail Fares

125. © Tutor2u Limited 2013 125
Case Study: Pricing Regime for Electricity and Gas changes from RPI-X to RIIO
For many years the real cost of electricity and gas distributed into millions of homes and business was falling
– this was partly due to increased retail competition in the industry and also because the gas and electricity
industry operated under an RPI-X pricing formula. The price controls were designed to allow gas and
electricity businesses to earn a post-tax real rate of return of around 5% together with enough extra profit for
capital investment in the energy generation, transmission and distribution network.
 RPI-X for the gas and electricity sectors is due to be replaced by RIIO
 RIIO stands for Revenue=Incentives+Innovation+Outputs
 RIIO brings in eight-year pricing controls – an increase on the current five-year regime, designed to
encourage gas and electricity businesses to make long term investments in the network
 According to Ofgem, the new RIIO framework rewards companies that innovate and run their
networks efficiently to better meet the needs of consumers and network users
 Pricing controls will remain in place but price changes will allow for increased investment in energy
grids, some of the extra costs of this will be passed onto household and consumer bills
 RIIO puts specific focus on key outputs from the industry – namely:
o Customer satisfaction
o Reliability and availability
o Safe network services
o Environmental impact and other social obligations
Index of consumer prices, 2005=100
Electricity and Gas Prices compared with changes in the CPI
All items (CPI) Gas Electricity
Source: Reuters EcoWin
05 06 07 08 09 10 11 12
75
100
125
150
175
200
225
Index
75
100
125
150
175
200
225
Consumer Price Index (all items)
Gas Prices
Electricity Prices

126. © Tutor2u Limited 2013 126
Case Study: Stamp Prices in the UK
The postal service industry in the UK has undergone significant structural change in recent years. The
industry was liberalised / opened up to competition firstly in parcels and more recently in the market for
collecting, sorting and delivering household and business mail. The near monopoly of the Royal Mail has
come under increasing threat and challenge from a growing number of new entrants who have been granted
a licence to operate in the UK – these new players include TNT, UK Mail and DHL.
The regulatory structure of the industry has changed - the Postal Services Act 2011 transferred regulation of
postal services from PostComm to Ofcom. A key part of the UK postal industry is the existence of a universal
postal service – this has two parts:
1. A national mail network – including once a day delivery to every postal address in the UK
a. Royal Mail is required to deliver six days a week
b. 93% next day delivery target
2. An affordable universal tariff / pricing system – delivering a fair rate of return for postal businesses
but also taking into account affordability for all consumers
The Royal Mail Group is the only licence business in the UK thought capable of meeting this universal postal
service. Royal Mail has made big efforts in recent years to increase efficiency and cut costs but they face the
problem of a long-term fall in the volume of first and second class mail being sent (there are many cheaper
alternatives!). They make a loss on each second class letter sent; this is largely funded by profits elsewhere
in the mail market and exploiting economies of scale from their postal network. In 2010-11, the Royal Mail’s
Letters & Parcels International business had an operating loss of £120 million.
Competition has posed many challenges for the Royal Mail, since the market was opened up to new
licenced businesses, competitors have been winning business to collect and sort mail, paying to use Royal
Mail’s delivery network. In a wide-ranging review in 2011, Ofcom decided to give the Royal Mail more
commercial freedom to set postage charges over a seven year period. Subject to maintaining a universal
postal service and achieving year on year improvements in efficiency, Ofcom has almost entirely removed
price controls on the Royal Mail. It has however set a cap on the price of a second class stamp at 55p with
Royal Mail given freedom to determine the cost of a first class stamp. The price cap on second class stamps
will rise in line with the consumer prices index (CPI).
Index, 1987=100, monthly data, source: UK Retail Price Index
Retail Price Index (RPI) and Index of Postage Prices
Household services, postage All items (RPI)
Source: Reuters EcoWin
87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
100
150
200
250
300
350
400
Index
100
150
200
250
300
350
400
Retail Price Index
Postage prices

127. © Tutor2u Limited 2013 127
UK Stamp price changes in April 2012
Product April 2011 April 2012 % change in stamp prices (2011-12)
First Class stamp (standard) 46p 60p 30%
Second Class stamp (standard) 36p 50p 30%
First Class stamp (Large Letter) 75p 90p 29%
Standard Parcel up to 2kg £4.41 £5.30 20%
Will these stamp price increases lead to a steep decline in the volume of mail sent? The answer depends on
the price elasticity of demand for postal services. Digital competition will probably be an effective deterrent to
the Royal Mail if it wants to raise stamp prices further. The regulator also stands by to see if improved
financial performance is largely the result of stamp price hikes or more favourably, the end-product of
improvements in productive efficiency throughout the business.
Evaluation: Judging the Effectiveness of Regulators
There is no such thing as a free market; every industry in the UK is subject to some form of regulation and in
this chapter we have focused on price regulation in a number of utility sectors. Regulations have an effect on
the structure of an industry – for example measures to introduced fresh competition. They also have a
bearing on other indicators of market performance – these are known as outcomes.
Trends in real price levels for consumers over time
Size of profits – evidence of excess profits?
Employment levels, investment in employee training
Customer satisfaction, performance targets
Spending on research and development – technological advance
and innovation?
Changes in labour productivity
Environmental indicators - e.g. progress in cutting emissions /
renewables targets
Investment in new capacity / infrastructure to meet future
demand challenges

128. © Tutor2u Limited 2013 128
27. Government Intervention - Privatisation and Nationalisation
What is Privatisation?
 Privatisation means the transfer of assets from the public (state or government) sector to the
private sector of an economy – privatisation causes a change of ownership
 In the UK the process has led to a reduction in the size of the public sector. State-owned enterprises
now contribute less than 2 per cent of GDP and less than 1.5% of total employment.
 Privatisation has become a common feature of micro-economic reforms throughout the world not
least in many transition economies including a large number in eastern Europe
 But over recent years privatisation in the UK has given way to a new wave of nationalisation
including some high profile banks, building societies and transport services.
Major Privatisations
The major privatisations in the UK over the last thirty years have occurred with the following businesses (the
year of privatisation is in parenthesis).
o Associated British Ports (1983)
o British Aerospace (1980) – eventually
merged with Marconi Electronic Systems
o British Airports Authority (1986) – bought
by Ferrovial in 2006
o British Airways (1987)
o British Coal (1994) – in 1994, UK Coal’s
assets were merged with RJB Mining to
form UK Coal plc
o British Gas (1986) - In 1997 British Gas
plc de-merged Centrica plc and renamed
itself BG plc (later BG Group plc). in
Britain it is used by Centrica, while in the
rest of the world it is used by BG Group
o British Petroleum – Gradually privatised
between 1979 and 1987. In August 1998,
British Petroleum merged with the Amoco
Corporation (Amoco), forming "BP
Amoco."
o British Rail (privatised in stages between
1994 and 1997) – created Railtrack – it
was renationalised in 2002.
o British Steel (1988) – British Steel merged
with the Dutch steel producer Koninklijke
Hoogovens to form Corus Group on 6
October 1999. Corus was bought by
Indian steel firm Tata in 2007.
o British Telecom (1984) – sold in a £4bn
floatation (51% sold) – further tranches
sold off at later dates
o National Power and PowerGen (1990) -
1990 the Central Electricity Generating
Board was split into three generating
companies (PowerGen, National Power
and Nuclear Electric plc.) and electricity
transmission company, National Grid
Company.
o Regional water companies
o Plasma Resources UK – a blood plasma
business sold to Bain Capital in 2013
o British Waterways – became a charitable
trust in 2012
o The Tote – sold to Betfred in 2011
In July 2013, the Coalition government announced plans to privatise the Royal Mail before the end of 2014
Changing nature of privatisation in the UK
 The early examples of privatisation such as the sale of British Telecom to the private sector in 1984
represented a simple transfer of ownership as shares were offered for sale via the stock market.
 More recently the privatisation process has become more complex. The focus has switched to
breaking up existing statutory monopoly power through a process of deregulation and
liberalisation of markets – basically designed to introduce competition where once monopoly
power was well established.
 Market forces have been introduced in social services, the NHS and in higher education.

129. © Tutor2u Limited 2013 129
The Public Sector of the UK Economy
What is best provided by the market? And what might be best
provided by the government sector of the economy? The state has
a shareholding in many companies including the following:
 British Nuclear Fuels plc - an international company,
owned by the British government, concerned with nuclear
power.
 Network Rail - Network Rail is a "not for dividend" company
that owns the fixed assets of the UK railway system that
formerly belonged to British Rail, the now-defunct British
state-owned railway operator. Network Rail owns the
infrastructure itself, railway tracks, signals, tunnels, bridges,
level crossings and most stations, but not the rolling stock.
Network Rail took over ownership by buying Railtrack plc,
which was in "Railway Administration", for £500 million
from Railtrack Group plc.
 East Coast Rail Line – state-owned railway that operates
on routes totalling 936 miles, from London to
Peterborough, the East Midlands, Leeds, York, Newcastle,
Edinburgh and beyond to Aberdeen, Inverness and
Glasgow. Took over the franchise from National Express
 The Tote – a betting business that remains in state
ownership and has done since it was created by an act of
parliament in 1928. The government has announced plans
to privatise the business but this has not yet been
completed in part because of difficult stock market
conditions following the credit crunch and the recession.
 Bradford and Bingley - In September 2008 the UK
government nationalised Bradford and Bingley - it took
control of the bank's £50bn mortgages and loans, while
B&B's £20bn savings unit and branches was bought by
Spain's Santander.
 Royal Bank of Scotland: On the 13 October 2008 the UK
government announced its plan to save the Royal Bank of
Scotland from failing. It agreed a bail out of the bank in
return for taking a seventy per cent stake in the business.
The government also has a 43 per cent stake in Lloyds
Banking Group
 Urenco – the UK government has a 33% stake in this
uranium enrichment company, the Dutch government also
holds a 33% stake.
 Other state-owned businesses (as of July 2013) include:
Companies House, the Land Registry, the Met Office,
Ordnance Survey, the Student Loan Book and the Nuclear
Decommissioning Authority. The state also has a stake in
Channel 4 Television, Eurostar, the Royal Mint and the
newly established Green Investment Bank
Network Rail is a quasi-private
company that owns and operates
the country’s mainline network.
Its debts are backed up by
government. Network Rail owns
and operates the UK's railway
infrastructure. Their stated
objective is "Building a safer,
smarter, bigger, greener network
– every day."
It is achieving rising revenues but
remains heavily reliant on state
subsidy. It runs a network
creaking under capacity
constraints - passenger numbers
are growing well ahead of
forecast. 529 million more
passenger journeys per year have
been completed on time
compared to 2002 but Network
Rail faces problems over failing
to meet tougher punctuality
targets.
Key funding streams for
Network Rail
£2bn in charges from Train and
Freight Operators
£250m from real estate
£4bn in DIRECT government
funding
Network Rail reported it had
made a record annual investment
in the year to March 31, 2013, on
Britain’s railways, spending £5bn
at a rate of £14m a day on 2,000
projects nationwide. Here is one
example - the Borders Railway
Project will connect the Borders
with Edinburgh for the first time
in 40 years

130. © Tutor2u Limited 2013 130
Case Study: East Coast Rail Line is nationalised
The profitable East Coast rail line north of
Newcastle heading into Northumberland towards
Berwick upon Tweed is one of the most glorious on
the entire British rail network. There are stunning
views looking out to Holy Island, Bamburgh Castle
and the village of Alnmouth. And as trains pull out of
Durham there is a fantastic panorama featuring
Durham Cathedral, a view to take the breath away
whatever the weather. Even the most hardened
commuter is tempted away from their laptop to soak
up the view. It is unlikely that senior executives at
National Express will be in the mood to savour these delights since the government is taking the East Coast
rail line that runs from London to Edinburgh into public ownership.
National Express has struggled with falling revenues and higher costs that have contributed to rising losses
on the line. In effect the nationalisation prevents National Express from re-entering the market when new
franchises become available.
The rail franchise suffered greatly from the huge financial commitments it made to the government when
bidding successfully to operate the line and has a £1.2bn debt pile. Under the terms of the franchise
agreement, National Express is required to pay the government £1.4bn to run the East Coast line until 2015,
with the amount rising steeply from £85m in 2008 to £395m this year. In order to meet its targets, the
franchise requires passenger revenue growth of about 10% per year, but turnover has been affected by the
recession which has cut the volume of business travel and prompted many to trade-down from first class to
standard class travel. In this sense National Express is no different to the problems facing airlines such as
British Airways whose premium passengers have long been a key source of revenue. They have been
criticised for their high walk-on fares, indeed a business that charges £266 for a Newcastle-London peak
return journey and still cannot balance the books perhaps deserves to be dumped by the government?
The government may have to wait until macroeconomic conditions improve to find a buyer for the East
Coast franchise; the expectation is that public ownership will last for about a year. The government wanted
to send a message to other businesses in the sector that they are keen to avoid moral hazard - no operator
is too big to lose their franchise.
Since rail privatisation in 1994, train lines have been operated using a franchise policy through which the
government effectively outsources the operation of 19 British rail routes to privately owned companies. On
most franchises, it gives operators a multimillion pound subsidy to help pay charges for using the tracks,
which are levied by the state-owned Network Rail, who run Britain's tracks, signals and stations. Among the
remaining train operating companies, First Group, Stagecoach/Virgin, Go-Ahead and Arriva now dominate
train operating company landscape. How long will it take before we arrive back at a pre-privatisation situation
with just one national train operating company and one business (Network Rail) managing the network?
For National Express the failure of the business to make the East Coast line a success will damage their
reputation - it is a timely example of the exit costs linked to entering a market.
Source: Tutor2u Economics Blog, June 2009

131. © Tutor2u Limited 2013 131
Privatisation – Is it Good or Bad for Economic Efficiency?
 Supporters of privatisation believe that the private sector and the discipline of free market forces are
a better incentive for businesses to be run efficiently and thereby achieve improvements in
economic welfare.
 Privatisation was also seen as a way of reducing trade union power, widening share ownership
and increasing investment, as privatised businesses were now free to raise finance through the
stock market. Privatisation was regarded as an important supply-side policy designed to drive
competition and improve productive and dynamic efficiency.
Opponents of privatisation argued that state owned enterprises had already faced competition when part of
the public sector and that in several instances the transfer of ownership merely replaced a public sector
monopoly with a private sector monopoly that then required regulation.
There were criticisms that state assets were sold off by the government at too low a price and that the
consequences of privatisation has been a decrease in investment and large scale reductions in employment
as privatised businesses have sought to cut their operating costs.
Deregulation of markets
Deregulation involves opening up markets and encouraging the entry of new suppliers. Examples of this in
the UK include the opening up of markets for bus services, household energy supplies, the liberalisation of
household mail services and financial deregulation affecting both banks and building societies.
The expansion of the European Single Market has accelerated the process of market liberalisation. The
Single Market seeks to promote four freedoms – namely the free movement of goods, services, financial
capital and labour. In the long term we can expect to see the microeconomic effects of the EU Single Market
working their way through many British markets and the general expectation is that competitive pressures for
all businesses working inside the European Union will continue to intensify.
Product market liberalisation involves breaking down barriers to entry, boost market supply, bring down
prices for consumers, and encourage an increase in competition, investment and productivity leading to a
rise in economic efficiency. In the long term, if product markets become more competitive and investment
flows into these industries, there are macroeconomic implications for example an increase in an economy’s
underlying trend rate of economic growth which might contribute to an improvement in average standards of
living.
Case Study: Is there a future for NHS dentistry?
In 2006 the government introduced a series of reforms for NHS dentists which included the scrapping of
system of registration whereby dentists had a list of patients. A chronic shortage of dentists operating within
the NHS led to huge queues of people outside practices where a new NHS dentist had become available.
Under the terms of the new contract dentists were paid to carry out a set number of courses of treatment in
the hope that this would give them more time to spend with patients and an improvement in preventative
dentistry. But many dentists decided not to sign the contract and left the NHS to pursue a career in the
private sector. As a result demand for NHS dental care is still outstripping supply and patients are struggling
to get access in some places.
It costs the taxpayer £175,000 to train a dentist. If dentists receive training and then leave to work in private
practice, the NHS suffers from the free-rider problem. It has been suggested that newly qualified dentists
should have to serve a five year term within the NHS before having the freedom to move into the private
sector. Average earnings for NHS dentists stood at just over £96,000 in 2007. For the top-earning dentists
who own their own practice average income rose is £172,494.
Source: Tutor2u Economics Blog

132. © Tutor2u Limited 2013 132
Case Study: Privatisation of the Royal Mail
The coalition government has announced plans
to privatise the Royal Mail by selling a majority
stake in the business using an initial public
offering (IPO) which could value it at more than
£3 billion.
Trade union leaders oppose the plans fearing that a
move to the private sector will cost jobs and that the
commitment to a universal postal service will
eventually end. On or around the point of IPO,
Government will transfer 10% of its shares in Royal
Mail to an employee share scheme designed to
boost incentives for those who work for the business.
Background on the Royal Mail:
1. Ownership: The Royal Mail Group is currently a 100% Government-owned UK-wide company that
was established as a separate ‘sister’ company to Post Office Limited on 1 April 2012
2. Jobs: The Royal Mail has over 150,000 employees in the UK - a number of years of rationalisation
have cut this figure by tens of thousands.
3. Volumes: The traditional letters market remains in structural decline. Volumes in this market have
fallen by more than 25 per cent since 2005-06.
4. Universal service requirement: The Royal Mail is required by law to provide a universal postal
service - including delivery to any address throughout the UK six times per week, and a sufficient
network of letter boxes and post offices
5. Revenues: the Royal Mail has annual revenue of £9.3 billion of which just under half comes from
letters, around £4 billion from parcels and the remainder from marketing mail services.
6. Improving finances: Royal Mail Group has improved its financial performance considerably in
recent years; the latest gross operating profit margin was 4.4% although this is less than businesses
such as Deutsche Post which has achieved operating profit margins closer to 8%. Operating profits
for the Royal Mail for the 52 weeks to the end of March 2013 was £403m
7. Competition: The main rivals in the UK mail industry for the Royal Mail are Deutsche Post and TNT
8. Parcels: The collection, sorting and delivery of letters has been a loss-making exercise for the Royal
Mail for some years now but the parcels business is much more profitable helped by the rapid
growth in online shopping and fulfilment. The government believes Royal Mail needs access
to private sector capital to invest as it continues to change into a parcel-focused business.
9. Prices of letters: In the last two years, the Royal Mail has been given more freedom by industry
regulator OFCOM to decide on the price of a first class stamp, but with a cap set on the cost of a
second class stamp at 55p. From 30 April 2012, the cost of a first class stamp for a letter was
increased from 46p to 60p; the cost of a second class stamp for a letter increased from 36p to 50p
The postal services market has been opened up to increasing competition in recent years with postal
businesses able to apply for a licence to operate in competition to the Royal Mail. There are two main
channels available to new competitors:
Access competition is where the operator collects mail from the customer, sorts it and then transports it to
Royal Mail’s Inward Mail Centres, where it is handed over to Royal Mail, who are paid to deliver it. Nearly
40% of mail is now covered by access competition
End-to-end competition – this is where an operator other than Royal Mail undertakes the entire process of
collecting, sorting and delivering mail to the intended recipients. Thus far few businesses have chosen to
offer this. TNT Post began trailing end-to-end delivery operations in West London in April 2012

133. © Tutor2u Limited 2013 133
Private Sector Firms providing Public Services – Outsourcing
In recent years there has been strong growth in the number of private sector businesses that are used to
provide public services. For example the running of prisons and social care homes might be out-sourced by
central and local government to private sector providers often after a tendering or bidding process has been
held. This is known as contracting-out.
Case for out-sourcing
1. Opening public services up to competition can save the tax payer money
2. Private sector businesses more likely to achieve efficiency improvements and cost savings – leading
to improved value for money
3. Businesses in the private sector might be more innovative, less hierarchical and less prone to
suffering from diseconomies of scale
Criticisms of outsourcing
1. Businesses bidding to win contracts might sacrifice quality of service as a way of lowering their costs
2. Doubts about some employment practices of service companies e.g. low wages, poor conditions
3. Contracting-out / outsourcing requires proper monitoring which itself involves extra spending
Outsourcing providers in the UK
Two well-known examples of businesses that provide outsourcing services are G4S and Serco.
Serco:
This is a huge service provider: It is the biggest manager of air traffic control
towers worldwide; runs border control services, hospitals, commuter
transport in Dubai and London, and even the European Space Agency.
Serco is one of the largest managers of leisure centres as well as Ofsted
school inspections, welfare-to-work services, community care, the Atomic
Weapons Establishment and Boris bikes. There are also prisons and an
immigration detention centre in Australia. Pre-tax profits in 2012 were £250m
on revenue of £1.3 billion.
G4S:
G$S employs over 155,000 people in the UK and in 2012 had a turnover of
over £1.6 billion. It is one of the UK government’s largest providers of services
such as manned event security, cash transfer and security, monitoring
prisoners and custodial & detention services as part of the justice process.
Both firms have been subject to fierce criticism over the last few years. G4S
for example was embroiled in the fiasco over staffing for Olympic security
ahead of the 2012 London games. And in the summer of 2013, the UK
government announced an investigation into all their contracts, following
allegations that G4S and Serco overcharged it by tens of millions of pounds
for electronic tagging of offenders.

134. © Tutor2u Limited 2013 134
28. The Private Finance Initiative (PFI)
1. The Private Finance Initiative (PFI) is an important but controversial policy designed to change the
model of funding for large-scale investment projects
2. The PFI was first launched in 1992 by a Conservative government and was extended heavily by the
Labour government of 1997-2010. At the end of 2011, more than 700 hospitals, schools, prisons and
other public sector projects had been built under the PFI scheme
3. It encourages groups of private investors manage the design, build, finance and operation of public
infrastructure such as new schools, hospitals, social housing, defence contracts, prisons and road
improvements. Typically a PFI contract is repaid by the government over a 30 year period
4. Under PFI, major projects including new infrastructure is built by the private sector, the government
uses the resource over the long term, 25-30 years, it is a partnership between private and public
sector
Evaluation: What are some of the Benefits of the PFI?
1. Efficiency: Belief that the private sector is better at managing investment projects and achieving
overall cost efficiencies than the public sector
2. Extra Investment: Extra funding can kick-start more projects – bringing economic and social
benefits. The PFI provides private sector funds for projects that might prove difficult for the
government to finance through higher borrowing and taxes e.g. 22 NHS trusts use PFI for building.
Projects supporting health or education will improve productive capacity, increase economic growth
and can therefore be funded out of future incomes that the projects help to generate
3. Delivery: The private sector is not paid until the asset has been delivered. New PFI projects are
nearly all fixed price contracts with financial consequences for contractors if delivered late. PFI firms
pay tax which in theory could make the projects cheaper overall for the government
4. Dynamic efficiency: Private sector better placed to bring innovation and good design to projects,
higher quality of delivery, lowering maintenance costs
Evaluation: What are some of the Disadvantages of PFI?
1. Debt costs: Since 2007 the cost of private sector finance has increased - financing costs of PFI are
typically 3-4% over that of government debt. Some estimates find that paying off a £1bn debt
incurred through PFI cost the UK taxpayer equivalent to a direct government debt of £1.7bn
2. Inflexibility and poor value for money: Long service contracts may be difficult / costly to change –
especially when the management of a project seems to have gone wrong. There have been many
stories of flawed projects for example private firms contracted out to provide car parking, cleaning
and other services in hospitals built and run as part of a PFI. Infrastructure may not designed to last
more than the length of the contract and will need replacing or maintenance costs will be high
3. Risk: The ultimate risk with a project lies with the public sector (government). Private finance
agreements are complicated to organise and there is no guarantee that the private sector will make
a better cost benefit analysis of a project than the public sector
4. Administration: High spending on advisors and lawyers and the costs of the bidding process. The
Royal Institute of British Architects estimated that the cost of bidding for a PFI hospital was more
than £11 million
5. Addiction: Governments can become addicted to PFI - "the only game in town" rather than using
government borrowing for key projects. The PFI has added to public sector debt but created many
private sector fortunes
The media is rife with examples of some of the wasteful spending built into the public sector procurement
agreements that are part of PFI projects – for example the Prison Service renting computers for £120 per
month, anger at rising car parking charges at many local hospitals, road and bridge projects over-budget (the
M25 widening scheme cost £1 billion more than forecast. Another well known example is the kennels at the
Defence Animal Centre in Melton Mowbray, which cost more per night than rooms at the London Hilton.
A good recent example of a PFI project is the Olympic Delivery Authority which delivered the 2012 London
Olympic Games.

135. © Tutor2u Limited 2013 135
Case Study: Should the UK Government Build New Super-Prisons?
The UK government should close down
more than 30 of the UK’s most decrepit,
poorly run jails and replace them with 12
super-prisons housing about 3,000
inmates each, new research suggests.
The proposed prisons would cost £3.75bn
and are expected to save about £600m a
year, according to a report by Policy
Exchange, the right-leaning think-tank.
The age profile of the existing UK prison
estate remains skewed towards older, less
efficient and high maintenance
establishments.
Around a quarter of prison capacity in the
UK is in prisons that are Victorian, or older.
Most of these are the traditional large, city-
centre local prisons, such as Wandsworth,
Wormwood Scrubs and Brixton. Another
quarter of the estate is comprised of
facilities constructed in the 1960s and
1970s, often to poor standards and designs
and with poor materials
Opponents argue that housing offenders in huge buildings can increase reoffending and makes inmate
management more difficult. Wandsworth, the UK’s largest jail, has more than 1,600 inmates and inspectors
have noted the challenges of managing its unwieldy population.
Juliet Lyon, director of the Prison Reform Trust, said introducing super-prisons would be a “gigantic mistake”
and that money would be better spent improving mental healthcare, drug treatment and alternatives to
custody rather than ineffective jail sentences.
North Wales has been chosen as the site of a £250m super prison which the Ministry of Justice says will
create 1,000 jobs. It is expected to be built on a site on a Wrexham industrial estate by 2017. The new prison
will be built as a Private Finance Initiative project.
Adapted from news reports, April 2013

136. © Tutor2u Limited 2013 136
Competition Policy Overview – Ways of Enhancing Competition in Markets
The assumption underlying most of competition policy in the EU including the UK is that measures designed
to strength competitive pressures are important as a way of improving microeconomic outcomes in different
markets and industries. Often, achieving more competition requires initial legislation before new businesses
and products make their appearance.
Here are some of the main ways to promote competition and contestability in markets:
De-regulation- laws to reduce monopoly power
• Preventing mergers/acquisitions that create a monopoly
• Laws to introduce competition into the postal services industry
• Forced sales of assets e.g. BAA and airports in the UK
Privatisation - transferringownership
• Stock market floatation of the Royal Mail
• Part-privatisation of Network Rail similar to the sell-off of HS1 - the high-
speed link that connects London’s St Pancras to the Channel tunnel, on a
long-term concession
Tough laws on anti-competitivebehaviour
• Strong laws and penalties against proven cases of price fixing or collusion
that involves market sharing
• Companies breaching EU and UK competition rules risk hefty fines of up
to 10 per cent of global turnover - senior executives can be jailed
Reductions in import controls
• A reduction in import tariffs encourages cheaper products from overseas
• Increasing or eliminating import quotas can also have the same effect
• Allowing new countries into the EU single market increases contestability

137. © Tutor2u Limited 2013 137
29. Industry in Focus - Water
Structure of the UK Water Industry
The English water and sewerage industry was
privatized in 1989 and since then household and
business consumers have received water
services from a regional monopoly business.
Companies such as Thames Water or Severn
Trent are vertically integrated, water companies,
which provide a ‘source to tap’ service: obtaining
water from source through abstraction, treating it
to an appropriate standard, and providing it to
customers’ taps via company-owned
infrastructure. Only very large business
customers are able to choose their supplier.
In Wales, Glas Cymru is a single purpose water
and sewerage company with no shareholders run
solely for the benefit of customers. Scotland and
Northern Ireland have retained the state-owned model.
Post privatization, an industry regulator OFWAT was created. Like other regulators OFWAT has a number
of roles including the aims of promoting the public interest and increasing cost effectiveness of the water and
sewerage suppliers. The water industry has been subject to price controls over the last twenty three years
with each price-control regime lasting for a period of five years. The current price control lasts until 2015.
OFWAT argues that their policies have delivered substantial benefits to both consumers and the
environment. They point to improved environmental compliance, with 98.6% of bathing waters meeting
required standards and 99.95% compliance in meeting EU standards for clean drinking water. Water
suppliers have reached a level of productive efficiency such that a liter of water is delivered and taken
away for less than half a penny. OFWAT points out that water and sewerage companies have invested about
£90 billion (in today’s prices) over the past two decades.
Explaining the rising cost of water bills
Despite this there are many critics of the performance of the industry
and the regulator. Annual customer bills have soared from an
average £64 to £376 since 2001 and an estimated 2.4 million
households have trouble paying their water bills. In addition, for many
years private water companies have been accused of not doing enough
to cut the rate of leakage. Here is an example. Severn Trent supplies
water and sewerage to households and industry across much of the
Midlands and mid-Wales and it loses about 20 per cent of its treated
output to leakages from its pipes. That is mid-range within an industry
average of 15 per cent to25 per cent lost. Rising bills, high leakage
rates and frequent hosepipe bans have combined to create a high level
of customer dissatisfaction with many water companies.
Meeting the challenge of ageing infrastructure
In their defence, regional water monopolies argue that they are
struggling to deal with 100-year-old water distribution networks
which are being gradually being replaced at 0.5 per cent a year. Cutting
leakages is an expensive business, replacing all the pipes in England
and Wales would cost an estimated £100 billion - and still leakage levels would only be halved. OFWAT has
the power to impose fines on water companies that fail to meet leakage reduction targets. In 2006, Ofwat
imposed an effective fine of £150m on Thames Water and in 2007 Severn Trent was fined £36m for
underreporting leakage rates.
The current system of pricing for the Water industry allows for above-inflation annual rises in water bills to
help provide extra finance for investment in infrastructure. As far as water leaks are concerned, Ofwat sets

138. © Tutor2u Limited 2013 138
leakage reduction rates, but leaks are only fixed when the cost of lost water outweighs the cost of repair –
this policy is known as Sustainable Economic Level of Leakage (SELL)
Increasing foreign ownership
The UK water industry has seen a number of foreign takeovers over the years, indeed in 2012 there are only
three water suppliers listed on the UK stock exchange. In 2001, Thames Water, with 8.5 million water
customers, 100 water treatment plants, 290 pumping stations and 235 reservoirs was acquired by
Germany’s RWE, one of Europe’s largest power utilities. It was then bought by Kemble Water, controlled by
Australian infrastructure fund Macquarie. More recently, Cheung Kong Infrastructure bought Northumbrian
Water for £4.74bn; Capstone, the Canadian infrastructure fund bought a controlling stake in Bristol Water for
£133m; the Abu Dhabi Investment Authority has acquired a 9.9 per cent stake in Thames Water’s holding
company Kemble and the China Investment Corporation, the country’s sovereign wealth fund has taken an
8.68 per cent stake in Kemble for an undisclosed sum.
Barriers to entry and contestability in the market
The vast majority of consumers have no choice over which business supplies water to their home. In this
sense there is virtually no competition at retail level and it is difficult to see how this might be changed with a
huge level of new investment into the water sector. The biggest barrier to entry is the need for any new
water supplier to gain access to treated water and sewerage treatment plants.
Some people believe that market reforms in the water industry could draw on lessons from structural
changes in electricity and gas sectors. New water “retailers” would buy water wholesale from existing
companies at prices regulated by Ofwat and seeking to win business from incumbents by offering preferable
prices and/or services to their customers. This system was introduced into Scotland in 2005.
Some believe that fewer water companies in the industry might boost the performance of the sector. Steve
Mogford, chief executive of United Utilities, and Richard Flint, chief executive of Yorkshire Water have been
reported as arguing that having just six to eight water companies in England would give greater opportunities
for economies of scale, leading to lower average bills for consumers and also allowing water to be moved
around more easily, helping to guarantee supplies to
customers.
Growing pressures on water supplies
Undoubtedly, the water supply industry across the UK
faces many challenges going forward including a changing
and unpredictable climate and the effects of population
growth, particularly in the south-east of England where
water is already scarce. Suppliers also face rising cost
pressures from tighter environmental standards including
implementing the EU Water Framework Directive which
covers water quality and protecting the eco-systems in
water systems from over-extraction.
Water pricing – should meters become universal?
At a more fundamental level many are now asking the question - is water for household and business use
under-priced? The cost of household supplies is less than £1 per day and some economists and industry
experts argue that introducing mandatory water metering is required to cut non-essential water consumption
and reduce the risk of water restrictions becoming more frequent in the years ahead. The Institution of Civil
Engineers (ICE) has made a call for universal metering and removal of regulations discouraging water
sharing between neighbouring companies. The Environment Agency wants most households in the South
East to have water meters by 2015 and all homes in Britain by 2030. Water meters cost up to £250 to install,
which is paid for by the customer through water bills. It costs around £10 per year to check the meters
although smart meters can be checked remotely.
As well as universal metering, ICE said discretionary tariffs should be introduced to protect the poor. These
would be known as social tariffs and would cut prices for Britain’s poorest households. Some water
companies are experimenting with seasonal tariffs where water is priced more highly during peak summer
months.
The twin challenges of climate change
and population growth mean that water
scarcity is likely to become an increasing
problem in the future. As water
resources come under increasing strain,
it will become crucial that water is used
wisely and its waste is minimized
Source: UK Government White Paper on
Water, 2011

139. © Tutor2u Limited 2013 139
Investment is also needed in increasing levels of water catchment. This might involve building new reservoirs
and constructing medium and small scale storage, such as household and community-scale rain water
harvesting and Sustainable Drainage Systems in urban and rural areas. Even individual households can
make a difference for example collecting raw rainwater in butts for use in gardening and car washing.
Company Average Annual
Household Bill £,
2012-13
Customers Revenues Owner
United Utilities £395 3.2 million £1.51bn FTSE-100 listed
Severn Trent £325 8 million £1.38bn FTSE-100 listed
Glas Cymru £427 3 million Not available Not-for-profit
Wessex Water £455 1.3 million £438m YTL Corporation (Malaysia)
Northumbrian Water £352 2.6 million £683m FTSE-250 listed
Thames Water £339 8.8 million £1.6bn Kemble Water Consortium
Anglian Water £423 6 million £448m Osprey Group
The average bill that comes through the letterbox of each household is made up of three parts:
 (35%) Operating costs – a contribution towards the day-to-day costs of running a water business
 (28%) Capital charges – providing revenue to cover the costs of improving and maintaining
companies’ assets such as treatment works
 (37%) The return on capital – a charge towards interest payments, a satisfactory rate of profit
(including dividends) and tax.
Water companies are permitted by the regulator to raise their annual water bills by a given percentage to
help generate the revenue to cover capital investment.
Water Consumption Background Notes
 Most households receive bills where the price is fixed depending on a home's ''rateable value''
 Around 40% of households have water metres installed where water is charged according to the
amount consumed
 The average water bill in England and Wales is £376, which costs 11 per cent of households more
than 5 per cent of their disposable income
 70 litres are used in the production of one apple, and 15,500 litres for one kilogram of beef
 UK daily water consumption per person is about 150 litres
 63% of daily water consumption at home originates from the bathroom and the toilet
 Global demand for water is forecast to outstrip supply by 40% by 2030 due to factors such as
population growth and climate change

140. © Tutor2u Limited 2013 140
30. Business Economics Glossary
Concept Glossary Entry
Abnormal profit Profit in excess of normal profit - also known as supernormal profit or monopoly
profit. Abnormal profits may be maintained in a monopolistic market in the long
run because of barriers to entry
Agency problem Possible conflicts of interest that may result between the shareholders
(principal) and the management (agent) of a firm
Allocative efficiency Producing goods and services demanded by consumers at a price that reflect
the marginal cost of supply
Anti-competitive
behaviour
Strategies designed to limit the degree of competition inside a market and
reinforce the monopoly power of established businesses
Asymmetric information Where different parties have unequal access to information in a market
Average cost Total cost per unit of output = Total cost / output = TC/Q
Average cost pricing Setting prices close to average cost. It is a way to maximise sales, whilst
maintaining normal profits. It is sometimes known as sales maximization
Average fixed cost
(AFC)
Total fixed cost per unit of output = TFC/Q
Average revenue (AR) Total revenue per unit of output = Price/Output
Average variable cost Total variable cost per unit of output = TVC/Q
Backward vertical
integration
Acquiring a business operating earlier in the supply chain – e.g. a retailer buys a
wholesaler, a brewer buys a hop farm
Barriers to entry Ways to prevent the profitable entry of new competitors – they may relate to
differences in costs between existing and new firms. Or the result of strategic
behaviour by firms including expensive marketing and advertising spending
Batch production When a factory makes a quantity of one form of a product or part, followed by a
quantity of another different form
Behavioural economics Branch of economic research that adds elements of psychology to traditional
models in an attempt to better understand decision-making by investors,
consumers and other economic participants
Bi-lateral monopoly Where a monopsony buyer faces a monopsony seller in a market
Brand extension Adding a new product to an existing branded group of products
Brand loyalty The degree to which people regularly buy a particular brand and refuse to or are
reluctant to change to other brands
Break-even output The break-even price is when price = average total cost (P=AC)

141. © Tutor2u Limited 2013 141
Business ethics Business ethics is concerned with the social responsibility of management
towards the firm’s major stakeholders, the environment and society in general
Capacity The amount that can be produced by a plant, company, or economy (industrial
capacity) over a given period of time.
Capital intensive When an industry or production process requires a relatively large amount of
capital (fixed assets) or proportionately more capital than labour
Cartel An association of businesses or countries that collude to influence production
levels and thus the market price of a particular product
Churn rate The rate at which a company loses customers for a product or service that
depends on repeat sales or regular customer usage
Collusion Collusion takes place when rival companies cooperate for their mutual benefit.
When two or more parties act together to influence production and/or price
levels, thus preventing fair competition. Common in an oligopoly / duopoly
Competition
Commission
Body that conducts in-depth inquiries into mergers, markets and the regulation
of the major regulated industries such as water, electricity and gas
Competition Policy Government policy which seeks to promote competition and efficiency in
different markets and industries
Complex monopoly A complex monopoly exists if at least one quarter (25%) of the market is in the
hands of one or a group of suppliers who, deliberately or not, act in a way
designed to reduce competitive pressures within a market
Concentration ratio Measures the proportion of an industry's output or employment accounted for by
the largest firms. When the concentration ratio is high, an industry has moved
towards a monopoly, duopoly or oligopoly. Share can be by sales, employment
or any other relevant indicator.
Conglomerate merger Joining together of two companies that are different in the type of work they do -
the acquisition has no clear connection to the business buying it
Consolidation Consolidation refers to the reduction in the number of competitors in a market
and an increase in the total market share held by the remaining firms.
Constant returns When long run average cost remains constant as output increases because
output is rising in proportion to the inputs used in the production process
Consumer surplus The difference between the total amount that consumers are willing and able to
pay for a good or service (indicated by the demand curve) and the total amount
that they actually pay (the market price).
Consumption tax A tax imposed on the consumer of a good or service. This can be levied at the
final sale level (sales tax), or at each stage in the production
Contestable market Where an entrant has access to all production techniques available to the
incumbents is not prohibited from wooing the incumbent’s customers, and entry
decisions can be reversed without cost. The crucial assumption for a
contestable market is that businesses are free to enter and leave the market

142. © Tutor2u Limited 2013 142
Cooperative outcome An equilibrium in a game where the players agree to cooperate
Corporate governance Practices, principles and values that guide a firm and its activities
Corporate strategy A company's aims in general, and the way it hopes to achieve them - strategic
objective which supports the achievement of corporative aims
Cost synergies Cost synergies are the cost savings that a buyer aims to achieve as a result of
taking over or merging with another business
Cost-plus pricing Where a firm fixes the price for its product by adding a fixed percentage profit
margin to the average cost of production. The size of the profit margin may
depend on factors including competition and the strength of demand
Cost-reducing
innovations
Cost reducing innovations causing an outward shift in supply. They provide the
scope for businesses to enjoy higher profit margins with a given level of demand
Countervailing power When the market power of a monopolistic/oligopolistic seller is offset by
powerful buyers who can prevent the price from being pushed up
Creative destruction First introduced by Austrian School economist Joseph Schumpeter. It refers to
the dynamic effects of innovation in markets - for example where new products
or business models lead to a reallocation of resources. Some jobs are lost but
others are created. Established businesses come under threat
Credit Union Financial co-operatives owned & controlled by members offering banking
products
Cross-subsidy A cross subsidy uses profits from one line of business to finance losses in
another line of business e.g. Royal Mail and 2
nd
class letters
Deadweight loss Loss in producer & consumer surplus due to an inefficient level of production
De-layering De-layering involves removing one or more levels of hierarchy from the
organizational structure. For example, many high-street banks no longer have a
manager in each of their branches
De-merger The hiving off of one or more business units from a group so that they can
operate as independently managed concerns
Deregulation Opening up of markets by reducing barriers to entry. The aim is to increase
supply, competition and innovation and bring lower prices for consumers
Diminishing returns Addition of a variable factor to a fixed factor results in a fall in marginal product
Diseconomies of scale
(internal)
A business may expand beyond the optimal size in the long run and experience
diseconomies of scale. This leads to rising LRAC
Dis-synergies Negative or adverse effects of a takeover or merger. E.g. disruptions that arise
from the deal which result additional costs or lower than expected revenues
Diversification Increasing the range of products or markets served by a business
Divorce between
ownership and control
The owners of a company normally elect a board of directors to control the
business’s resources for them. However, when the owner of a company sells

143. © Tutor2u Limited 2013 143
shares, or takes out a loan to raise finance, they sacrifice some of their control
Dominant market
position
A firm holds a dominant position if it can operate within the market without taking
full account of the reaction of its competitors or final consumers
Dominant strategy A dominant strategy in game theory is one where a single strategy is best for a
player regardless of what strategy the other players in the game decide to use
Due Diligence Due diligence is the process undertaken by a prospective buyer of a business to
confirm the details (e.g. financial performance, assets & liabilities, legal
ownership & issues, operations, market position) of what they expect to buy
Duopoly Any market that is dominated by two suppliers. Proctor & Gamble and Unilever
took 84 per cent of the UK market liquid detergent sales in 2005
Duopsony Two major buyers of a good or service in a market each of whom is likely to
have some buying power with suppliers in their market.
Dynamic efficiency Dynamic efficiency focuses on changes in the choice available in a market
together with the quality/performance of products that we buy. Economists often
link dynamic efficiency with the pace of innovation in a market
Economic risk The risk that a company may be disadvantaged by exchange rate movements or
regulatory changes in the country in which it is operating
Economies of scale Falling long run average cost as output increases in the long run
Economies of scope Where it is cheaper to produce a range of products
Enlightened self
interest
Acting in a way that is costly or inconvenient at present, but which is believed to
be in one’s best interest in the long term. E.g. firms accepting some short term
costs (lower profits) in return for long-term gains. Relevant to game theory
Equilibrium output A monopolist is assumed to profit maximise, in other words, aims to achieve an
output equal to the point where MC=MR
Excess capacity The difference between the current output of a business and the total amount it
could produce in the current time period.
Experience curve Pattern of falling costs as production of a product or service increases, because
the company learns more about it, workers become more skilful
External diseconomies
of scale
When the growth of an industry leads to higher costs for businesses that are
part of that industry – for example, increased traffic congestion
External economies of
scale
When the expansion of an industry leads to the development of ancillary
services which benefit suppliers in the industry – causing a downward sloping
industry supply curve. A business might benefit from external economies by
locating in an area in which the industry is already established
Exit cost A barrier to exit – the costs associated with a business halting production and
leaving a market - linked to the concept of sunk costs
First mover advantage A business first into the market can develop a competitive advantage through
learning by doing - making it more difficult and costly for new firms to enter

144. © Tutor2u Limited 2013 144
Fixed cost Business expense that does not vary directly with the level of output
Forward vertical
integration
Acquiring a business further up in the supply chain – e.g. a vehicle manufacturer
buys a car parts distributor
Franchised monopoly When the government grants a company the exclusive right to sell or
manufacture a product or service in a particular area
Freemium Business model in which some basic services are provided for free, with the aim
of enticing users to pay for additional, premium features or content
Game Theory A “game” happens when there are two or more interacting decision-takers
(players) and each decision or combination of decisions involves a particular
outcome (known as a pay-off.)
Herfindahl Index A measure of market concentration. The index is calculated by squaring the %
market share of each firm in the market and summing these numbers
Hit-and-run competition When a business enters an industry to take advantage of temporarily high
(supernormal) market profits. Common in highly contestable markets
Horizontal collusion Where there is agreement between firms at the same stage of the production
process to charge prices above the competitive level
Horizontal integration When companies from the same industry amalgamate to form a larger company
- firms are at the same stage of the production process
Hostile takeover A takeover that is not supported by the management of the company being
acquired - as opposed to a friendly takeover
Innovation Making changes to something established. Invention, by contrast, is the act of
coming upon or finding. Innovation is the creation of new intellectual assets
Innovation-diffusion The extent and pace at which a market adopts new products
Interdependence When the actions of one firm has an effect on its competitors in the market.
Interdependence is a feature of an oligopoly. In simple terms - when two or
more things depend on each other (i.e. business and society)
Internal growth Internal growth occurs when a business gets larger by increasing the scale of its
own operations rather than relying on integration with other businesses
Inventories Inventory is a list for goods and materials, or those goods and materials
themselves, held available in stock by a business
Joint-venture Agreement between two or more companies to cooperate on a particular project
or a business that serves their mutual interests.
Kinked demand curve The kinked demand curve model assumes that a business might face a dual
demand curve for its product based on the likely reactions of other firms in the
market to a change in its price or another variable
Laissez-faire “Leave alone” – a doctrine that a Government should not interfere with actions
of business and markets

145. © Tutor2u Limited 2013 145
Last mover advantage The advantage a company gains by being one of the last to sell a product or
provide a service, when technology has improved and costs are very low
Light-touch regulation An approach of government to managing business behaviour - prefers to
“influence” rather than “legislate/regulate” Carrot or stick?
Limit pricing When a firm sets price low enough to discourage new entrants into the market
Marginal cost The change in total costs from increasing output by one extra unit – the formula
for MC is ‘change in total cost divided by change in quantity
Marginal profit The increase in profit when one more unit is sold or the difference between MR
and MC. If MR = £20 and MC = £14 then marginal profit = £6
Marginal revenue The change in total revenue from selling one extra unit of output
Merger A merger is a combination of two previously separate organisations.
Merger integration The process of bringing two firms together once they have come under common
ownership. Often regarded as the most difficult part of any takeover or merger.
The integration process needs to cover “hard” areas such as IT systems and
marketing strategy as well as “soft” issues such as different business cultures
Metcalfe’s Law Coined by Robert Metcalfe, Metcalfe's law says that the usefulness of a network
equals the square of the number of users. This is linked to the concept of
network economies of scale
Minimum efficient scale Scale of production where internal economies of scale have been fully exploited.
Corresponds to the lowest point on the long run average cost curve
Monopolistic
competition
A market structure characterized by many buyers and sellers of slightly different
products and easy entry to, and exit from, the industry. Good examples include
fast food outlets in towns and cities
Monopoly profit A firm is said to reap monopoly profits when a lack of viable market competition
allows it to set its prices above the equilibrium price for a good or service without
losing profits to competitors
Monopsony When a single buyer controls the market for a particular good or service, in
essence setting price and quality levels, normally because without that buyer
there would not sufficient demand for the product to survive
Moral Hazard When someone pays for your accidents and problems, you may be inclined to
take less effort to avoid accidents and problems
Multinational A company with subsidiaries or manufacturing bases in several countries
Mutual interdependence The relationship between oligopolists, in which the actions of each business
affect the other businesses
Nash Equilibrium An idea in game theory - any situation where all of the participants in a game
are pursuing their best possible strategy given the strategies of all of the other
participants. In a Nash Equilibrium, the outcome of a game that occurs is when
player A takes the best possible action given the action of player B, and player B
takes the best possible action given the action of player A

146. © Tutor2u Limited 2013 146
Nationalization When a government takes over a private sector company
Natural monopoly For a natural monopoly the long-run average cost curve falls continuously over a
large range of output. The result may be that there is only room in a market for
one firm to fully exploit the economies of scale that are available
NGO Non-governmental organization (e.g. WWF, Greenpeace)
Non-price competition Non-price competition assumes increased importance in oligopolistic markets.
Competing not on the basis of price but by other means, such as the quality of
the product, packaging, customer service, etc.
Normal profit Normal profit is the transfer earnings of the entrepreneur i.e. the minimum
reward necessary to keep her in her present industry. The activities of the
entrepreneur are independent of the level of output. Normal profit is therefore a
fixed cost, included in the average, not the marginal, cost curve
Oligopoly An oligopoly is a market dominated by a few producers, each of which has
control over the market. However, oligopoly is best defined by the conduct (or
behaviour) of firms within a market rather than its market structure
Optimal plant size Optimal plant is the size where costs are minimized, i.e. when all economies of
scale have been obtained, but diseconomies have not set in. Sometimes the
size of a firm or plant is also limited by the size of the market
Pareto efficiency Where it is not possible for individuals, households, or firms to bargain or trade
in such a way that everyone is at least as well off as they were before and at
least one person is better off. Also known as an efficient outcome
Patent Right under law to produce and market a good for a specified period of time
Paywall Blocking access to a website which is only available to paying subscribers
Peak pricing When a business raises its prices at a time when demand has reached a peak
might be justified due to the higher marginal costs of supply at peak times
Penetration pricing A pricing policy used to enter a new market, usually by setting a very low price
Perfect competition Theoretical condition of a market where prices reflect complete mobility of
resources and freedom of entry and exit, full access to information by all
participants, relatively homogeneous products, and the fact that no one buyer or
seller, or group of buyers or sellers, has any advantage over another.
Perfect price
discrimination
When a firm separates the whole market into each individual consumer and
charges them the price they are willing and able to pay
Predatory pricing Setting an artificially low price for a product in order to drive away competition -
deemed to be illegal by the UK and European competition authorities
Price capping A government-imposed limit on the price charged for a product - otherwise
known as price capping. Often introduced as a way of controlling the monopoly
pricing power of businesses with a large amount of market power
Price ceiling Law that sets or limits the price to be charged for a particular good

147. © Tutor2u Limited 2013 147
Price discrimination When a firm charges a different price to different groups of consumers for an
identical good or service, for reasons not associated with costs
Price fixing Price fixing represents an attempt by suppliers to control supply and fix price at
a level close to the level we would expect from a monopoly
Price leadership When one firm has a clear dominant position in the market and the firms with
lower market shares follow the pricing changes prompted by the dominant firm
Price regulation Government control of prices, normally for utilities and other essential services
Prisoners’ dilemma A problem in game theory that demonstrates why two people might not
cooperate even if it is in both their best interests to do so. In the classic game,
cooperating is strictly dominated by defecting, so that the only possible
equilibrium for the game is for all players to defect. No matter what the other
player does, one player will always gain a greater payoff by playing defect.
Private equity Injection of funds by specialized investors into private companies with the aim of
achieving high rates of return
Private Finance
Initiative
The PFI is a means of obtaining private funds for public sector projects
Privatization The sale of state-owned companies to the private sector, normally through a
stock market listing. The opposite of nationalization
Procurement collusion Where companies illegally bid for large contracts by rigging bids to decide which
one of them gets the contract in advance.
Producer surplus The difference between what producers are willing and able to supply a good for
and the price they actually receive. The level of producer surplus is shown by
the area above the supply curve and below the market price
Product differentiation When a business seeks to distinguish what are essentially the same products
from one another by real or illusory means. The assumption of homogeneous
products under conditions of perfect competition no longer applies.
Production function The relationship between a firm’s output and the quantities of factor inputs
(labour, capital, land) that it employs
Productivity How much is produced per unit of input. Labour productivity, for instance, can
be calculated per worker, per hour worked, etc. Capital productivity is similar to
calculating a return from an investment
Profit The excess of revenue over expenses; or a positive return on an investment.
Profit margin The ratio of profit over revenue, expressed as a percentage. Mainly an
indication of the ability of a company to control costs
Profit maximization Profit maximization occurs when marginal cost = marginal revenue
Profit per unit Profit per unit (or the profit margin) = AR – ATC. In markets where demand is
price inelastic, a business may be able to raise price well above average cost
earning a higher profit margin on each unit sold. In more competitive markets,
profit margins will be lower because demand is price elastic

148. © Tutor2u Limited 2013 148
Public utility A company that provides public services, such as power, water and
telecommunications. Regulated by government, not necessarily state-owned
Regulated industry An industry that is closely controlled by the government
Regulatory capture When industries under the control of a regulatory body appear to operate in
favour of the vested interest of monopoly producers rather than consumers
Rent seeking behaviour Behaviour by producers in a market that improves the welfare of one but at the
expense of another. A feature of monopoly and oligopoly
Revenue maximization Revenue maximization is an output when marginal revenue = zero (MR=0)
Revenue synergies The ability to sell more products and services or raise prices after a business
merger e.g. marketing and selling complementary products; cross-selling into a
new customer base and sharing distribution channels.
RPI-X Pricing Formula This formula encourages efficiency within regulated businesses by taking the
retail price index (i.e. the rate of inflation) as its benchmark for the allowed
changes in prices and then subtracting X – an efficiency factor – from it.
Satisficing Satisficing involves the owners setting minimum acceptable levels of
achievement in terms of revenue and profit.
Saturation To offer so much for sale that there is more than people want to buy
Second degree price
discrimination
Businesses selling off packages of a product deemed to be surplus capacity at
lower prices than the previously advertised price – also volume discounts
Shareholder return Total return (dividends + increases in business value) for shareholders
Short run A time period where at least one factor of production is in fixed supply. We
normally assume that the quantity of plant and machinery is fixed and that
production can be altered through changing labour, raw materials and energy
Short-termism When a business pursues the goal of maximizing short-term profits because of a
fear of being taken-over or suffer a fall in their share price
Shut down price In the short run the firm will continue to produce as long as total revenue covers
total variable costs or put another way, so long as price per unit > or equal to
average variable cost (P>AVC)
Social enterprises Businesses run on commercial lines with profits reinvested for social aims –
often said to be built on three pillars – profit, people and planet
Socially responsible
investing
Also known as ethical investing; shareholders pursuing investment strategies
which seeks to maximize both financial return and social good
Spare capacity Spare, surplus or excess capacity is the difference between current output
(utilized capacity) and what can be produced at full capacity
Stakeholder Any party that is committed, financially or otherwise, to a company and is
therefore affected by its performance e.g. shareholders, employees,
management, customers and suppliers. Their interests do not always coincide

149. © Tutor2u Limited 2013 149
Stakeholder conflict Stakeholder conflict occurs when different stakeholders have different
objectives. Firms have to choose between maximizing one objective and
satisfactorily meeting several stakeholder objectives, so called satisficing
Static efficiency Static efficiency focuses on how much output can be produced now from a given
stock of resources, and whether producers are charging a price to consumers
that reflects fairly the cost of the factors used to produce a product
Strategic behaviour Decisions that take into account the market power and reactions of other firms
Sub-normal profit Any profit less than normal profit – where price < average cost
Sunk costs Sunk costs cannot be recovered if a business decides to leave an industry. The
existence of sunk costs makes a market less contestable.
Supernormal profit A firm earns supernormal profit when its profit is above that required to keep its
resources in their present use in the long run i.e. when price > average cost
Synergy When the whole is greater than the sum of the individual parts
Tacit collusion Where firms undertake actions that are likely to minimize a competitive
response, e.g. avoiding price cutting or not attacking each other’s market. Tacit
collusions is when firms co-operate but not formally, e.g. price leadership, or
quiet or implied co-operation, secret, unspoken cooperation
Takeover Where one business acquires a controlling interest in another business.
Takeovers are much more common than mergers.
Technical efficiency How well and quickly a machine produces goods. When measuring the technical
efficiency of a machine, the production costs are not considered important
Total cost Total cost = total fixed cost + total variable cost
Total revenue Total revenue (TR) is found by multiplying price (P) by output i.e. number of
units sold. Total revenue is maximized when marginal revenue = zero
Variable cost Variable costs are business costs that vary directly with output since more
variable inputs are required to increase output. Also known as prime costs
Vertical integration Vertical Integration involves acquiring a business in the same industry but at
different stages of the supply chain
Welfare economics The study of how an economy can best allocate scarce resources to maximise
the welfare of its citizens
Whistle blowing When one or more agents in a collusive agreement report it to the authorities
X-inefficiency A lack of real competition may give a monopolist less of an incentive to invest in
new ideas or consider consumer welfare
Zero-sum game An economic transaction in which whatever is gained by one party must be lost
by the other. In a zero sum game, the gain of one player is exactly offset by the
loss of the other players. If one business gains market share, it must be at the
expense of the other firms in the market

150. © Tutor2u Limited 2013 150