Objectives

What motivates a firm? a) Directors and Managers Shareholders in a PLC will elect directors to look after their interests in the company. Directors appoint managers to manage and run the company. Owners influence decisions through the Annual General Meeting (AGM) b) The workers They dont the power to run the company, but collectively that may be able to influence decisions through the trade unions, which may exert influence over wages (and therefore costs), job losses, health and safety. c) The consumers They can influence the work of businesses through their demand patterns, if a firm fails to provide goods that consumers demand they will eventually cease trading as in the case of Rover Cars in 2005. Short-run profit maximisation Shareholders will be motivated by maximising their profits from the company - dividends. However, not all firms are able to operate at a profit; some will be faced with making a loss.

Long-run profit maximisation Keynesian economists believe that firms will seek to maximise their long run rather than their short-run profits. Firms will use cost plus pricing - the price of the product is worked out by calculating the AC, when the firm is operating at full capacity and adding a mark-up. Short-run profit maximisation suggests that firms adjust price and output in response to changes in market conditions. However, most economists agree that rapid price changes may affect a firms position in the market. Consumers dislike rapid price adjustments, and often view price cuts a signs of desperation and distress. A firm might continue to operate in the SR even if it were making a loss. The management would hope to be able to turn the business around and make profits in the long run.

Managerial theories Some managers would seek to maximise sales rather than profits. Its often the case that increased sales go hand in hand with increased salaries for top executives. Other managers are motivated by factors, such as high salaries, the number of people under their control, the power they can yield over investment decisions and the availability of fringe benefits. This idea originates from the concept that managers in large firms will have enough discretion to pursue policies giving them personally most satisfaction.

However, profit remains a shareholders best measure of success. Managers and directors are prone to shareholder revolts, and may even get voted out of office. Managers will profit satisfice, in other words, satisfy the demands of shareholders. Once those demands have been met, managers would be free to maximise their own rewards from the company.

Profit maximisation Basic assumption is that all businesses will seek to maximise their profits. Profit maximisation is MC=MR.

Oligopoly is the one to which the objective of profit maximisation seems least applicable. As a result, other theories have been developed. They often dont because: -Lack of knowledge of MC and MR. -Difficulty in predicting appropriate response when demand conditions change. -Internal bureaucracy resulting in X inefficiency, slow organisational response to external change. -Divorce of ownership and control. -Social and other pressures.

Revenue maximisation Baumol proposed a model of the form based on the principle that the primary objective of the managers of a firm is to maximise sales revenue. Revenue maximisation is MR=0.

The primary season, however, is seen to be that the salaries and status of managers are more closely linked to sales revenue growth than profit maximisation.

The model still recognises the need to make profits, but its a constraint on managerial behaviour rather than an objective. Minimum level of profit is required to satisfy shareholders, hence revenue may be maximised subject to achieving this minimum profit level. Managers may seek to maximise sales revenue for a variety of reasons: -Consumers would view the firm with falling sales in a less favourable light. -Financial institutions may be less willing to lend to a firm with falling sales. -Falling sales may result in reduction in staffing levels including managers.

Sales maximisation Sales maximisation is AC=AR.

The model assumes a separation between management and ownership and a sales market with a low level of competitive activity. It is also assumed that managers relate their salaries and statues to the size of the firm. Any growth in the size of the firm enhances their salaries and status within the firm. They therefore see the growth of the firm as one of their major objectives. On the other hand they fear takeovers by other firms as this may result in a loss of status and scope for salary increases. Takeover attempts are deemed to result from a depressed share valuation below the market valuation as judged by the firm considering the takeover. The main source of growth, through internal growth and diversification, depends upon a high level of retained profits for re-investment, however this creates a dilemma because a high level of retention implies a low level of dividend payments to shareholders, which reduces the market valuation of the company. The management is faced with a trade off situation between the dividend policy and retained profits and must seek the optimal balance between the two. A growth maximising management might choose to increase the size of the firm up to the point where AC=AR so the firm will have expanded up to the point where normal profits are being made. To increase the size beyond this point would result in the making of losses. Sales revenue maximisation the level of output would be greater and the price lower than the under profit maximisation. If the minimum profit constraint were in excess of normal profit, the level of output would have to be reduced. When dividends are low the share prices are low and takeover attempts are likely.

 The firm only makes normal profit when TR=TC. It makes maximum revenue when the TR curve is at its highest. It makes maximum profit when the gap between TR and TC is at its greatest. Profit maximisation to revenue maximisation

Behavioural theories Behavioural theories focus on internal decisions making structure of the firm. The aim is to understand this decision-making process rather than try to make predictions about price and output. A firms management will attempt to set itself minimal standards of achievement intended only to ensure the firms survival and a level of profit, which is acceptable to shareholders. Management attempts to achieve an acceptable level of performance for a number of operational goals. These goals reflect the objective of different groups in the coalition and frequently conflict. Businesses have little knowledge of their marginal costs and are not therefore in a position to make optimal price and output decisions necessary for profit maximising theories.

Growth of firms
Birth and growth firms During recession, more people have the initiative to start businesses since employment opportunities are more restricted. In growth periods, rising demand creates new opportunities for businesses.

Level of entrepreneurial talent in a country will also influence the number of businesses created, this will be influenced by attitudes to risk taking and level of education. Technological development can be a spur to innovation and businesses start up, as can government incentives. People can claim unemployment benefit in the first year. Firms which do survive will aim to grow for a number of reasons: -No cost advantage to being small. -Supplying specialist markets with non-standard production. -Personal attention is valued. -Supplying larger companies. -Bulk buying with other firms to gain economies of scale. -Large firms may like them because they may disguise restrictive practices.

Why do firms grow? Increase market share: They become a dominant firm in an industry. Larger firms find it easier and cheaper to raise finance. Larger firms likely to have more opportunity to influence price within the market. Benefit from greater profits: Aims to maximise profits and they can achieve this through expansion. Increased profits benefit shareholders who receive larger dividends. Increase sales: Through larger brand recognition and more sales outlets. Increase EOS: Firm is able to exploit their increased size. It drives down LRAC and approaches the minimum point on the LRAC curve and move closer to productive efficiency. Gain power: Prevent potential takeovers by larger predator businesses. However, an important constraint can be lack of access to capital in order to fund expansion or a lack of demand for the product produced. Larger firms choose not to grow if they fear investigation or regulation by government bodies.

Internal and external growth Firms can grow internally by reinvesting profits or externally by mergers or takeovers.

Diversification Conglomerate merger: Firms who merge with a company in a different industry. Diversification can enable a firm to grow when the market in which it is currently operating its saturated; it enables the company to spread its risk. However, the company may know nothing about the market it is entering which poses a significant risk and different skills may be required (synergy bringing together 2 businesses and getting more than original parts)

Horizontal integration It occurs when firms merge who are in the same industry at the same stage of production. It can reduce the number of competitors in the market, increase the firms market power and enable it to achieve economies of scale e.g. through rationalising management. Buying established brands may be an attractive option and cheaper than developing brands you to achieve organic growth.

Vertical integration Occurs when firms merge in the same industry but at different stages of production. Backwards-vertical merger - Firm takes over another firm whos at a prior stage of production. Forwards-vertical merger - Involve taking over a firm who is operating at subsequent stage of production. Vertical mergers can enable rationalisation in the production process and ensure supplies of raw materials or access to markets. Firms may deny market access to a competitor creating barriers to entry. By providing direct access to the customer, firms may be in a position to better understand and meet customer needs. There may be scope for some marketing economies of scale. Profits may increase by merging profit margins at each stage of production. Costs may decrease for e.g. it now has a guaranteed market and could reduce sales force. Greater quality control over inputs may give a non-price advantage. However, disadvantages include an over-dependency on one market, a lack of specialist knowledge in the new areas to improve efficiency and potential for diseconomies of scale e.g. managerial. The competition authorities may investigate if barriers to entry have been erected or monopoly power acquired. The firm may also face substantial costs in funding the merger/takeover, which may take many years of cost savings to recoup.

Alliances Cooperation between companies for a joint venture. E.g. Star Alliance within air transport creates a greater route network and more attractive air miles scheme than individual companies could achieve on their own. It provides a competitive advantage over non-members.

Demergers Large corporations have since been moving towards a focus on their core activities and therefore selling off some assets. Demergers can occur if a firm feels it is suffering from diseconomies of scale. Firms may also demerge if they feel that some parts of the business do not have any synergy with the core parts of the business, in other words, if they do not bring any benefits to the whole organisation.

Firms may demerge in order to raise finance to invest in their core activities or to reduce their debt servicing costs.

Revenue
Price 10 9 8 7 6 5 4 3 2 1 Demand 0 1 2 3 4 5 6 7 8 9 Total RevenueMarginal Revenue Average Revenue 0 0 0 9 9 9 16 7 8 21 5 7 24 3 6 25 1 5 24 -1 4 21 -3 3 16 -5 2 9 -7 1

A positive MR, a decrease in the price results in an increase in revenue, hence elastic ped. A negative MR, a decrease in the price results in a decrease in revenue, hence inelastic ped. When MR=0, ped = -1.

Marginal revenue The addition to TR of selling one more unit of output. The MR curve starts in the same place as the AR curve and crosses the xaxis halfway between the origin and the point which AR would touch the xaxis.

Average revenue AR = Total revenue/Quantity The revenue per unit sold.

Total revenue TR = Price X Quantity It can also be found by the area under the marginal revenue curve.

As the demand curve slopes downwards, price has to be reduced in order to sell more of a product, as a result, total revenue doesnt rise indefinitely. When MR is positive, TR is rising. When MR is negative, TR is falling. The TR curve starts at the origin; since revenue is 0 when quantity sold is 0.

Deriving AR and MR from the TR curve MR is shown by the gradient of TR, AR is shown by the gradient of the ray to the point under consideration.

Short run Short run: Period of time when one factor of input to the production process is fixed. Labour and raw materials are variable inputs. Capital is a fixed input. In the short run, a firm can only increase its output by combining increasing qualities of a variable factor with a certain amount of fixed factor.

Marginal product Marginal product: The addition to output produced by an extra unit of output. Marginal product: Change in total output/Change in the level of inputs

Law of diminishing marginal returns The law of diminishing returns states that as increasing quantities of a variable input are combined with a fixed input, the marginal product of that variable input will decline.

Average product Average product: The quantity of output per unit of input. Average product: Total product/Number of workers Average product tells you how much on average each of the current workers produce.

What if a firm can sell as much of its product as it wants without lowering the price? Demand would be perfectly elastic at the ruling market price. Since the firm does not have to lower price to increase demand, then marginal revenue will be constant and the same as the market price.

Costs
Total cost (TC) Total cost is the cost of all resources necessary to produce any particular level of output. Total cost always rises with output because to obtain more output requires more input i.e. factors of production - land, labour, capital and enterprise. TC = FC + VC

Fixed cost (FC) Fixed costs are also called indirect costs. Costs that do not vary with output. The costs remain constant whether the firm is producing or not e.g. rent. Such costs have to be paid even when output is zero. Variable cost (VC) Variable costs are also called direct costs. As a firm produces more output, so it needs more labour, raw materials and power. Variable costs are those, which vary with output. They are zero when output is zero and rise directly with output.

Average cost (AC) Average cost is the total cost divided by the number of units of the commodity produced. It is the cost per unit of output. AC= AFC + AVC.

Average total cost (ATC or AC) AC = TC/Q The curve is described as elongated U shape. Optimum level of output - the most efficient level of output - is where ATC is at minimum.

Average fixed costs (AFC) AFC = FC/Q The curve declines continuously with output in the short run as fixed costs are spread over a greater number of units of output. Fixed cost is positive so never touches the quantity axis.

Average variable costs (AVC) AVC = VC/Q The curve falls initially then rises due to the operation of the law of diminishing returns.

The AVC curve approaches ATC as output increases as AFC declines. AVC will not touch or cross ATC since AFC is positive.

Marginal cost (MC) Marginal cost is the addition to total cost of producing one more unit of output. It is relation to VC and not FC and will be affected by changes in VC. The marginal cost curve will always pass through the minimum of the AC curve. When MC < AC - AC will fall. When MC > AC - AC will rise. When AC=MC, AC must be at its minimum. When MC is high, costs are rising quickly. (vice versa) Since fixed cost is fixed, the increase in TC is from increases in VC. So MC=MVC. Changes in variable costs will shift the position of the MC curve, however, changes in FC will not change the position of the MC curve. AC and MC can be derived from the TC cost curve. AC is the gradient of the ray from the origin to the point at which AC is being calculated. MC is the gradient of the TC curve.

Costs in the short run and long run In the short run, at least one factor of production is fixed in supply. In the long run, all factor inputs are variable so there are no fixed factors in the long run. This means that the law of diminishing returns does not apply in the long run. As a result, the cost curves only apply in the short run.

Returns to scale Increasing returns to scale: When a proportionate increase in all factors of production leads to a more than proportionate increase in output. Decreasing returns to scale: When a proportionate increase in all factors of production leads to a less than proportionate increase in output. Constant returns to scale: When a proportionate increase in all factors of production leads to a proportionate increase in output.

Economies of scale Economies of scale: A fall in the long run average cost (LRAC) of a business as a result of an increase in size (unit cost decrease) Diminishing marginal unit cost - Each extra unit we produce cost us less. Internal economies of scale: Falling average costs of production which occur in the long-run as a firm increases its scale of production, they occur independently of what is happening elsewhere in the industry (e.g. labour specialising) External economies of scale: Rising average costs of production which occur in the long-run as a firm increases its scale of production, they occur independently of what is happening elsewhere in the industry (e.g. bulk buying) Rationalisation: Consolidating organisational structural to increase economic efficiency and lay off redundancies. As the industry grows, other businesses set up to service the industry, which can result in lower costs e.g. locating near to the industry and reducing transport costs. In the long run no factors of production are fixed so LRAC is made up from lots of SRAC. Internal and diseconomies of scale cause movements along the LRAC curve, whereas external economies and diseconomies of scale cause the whole LRAC curve to shift.

Industrial economies of scale Increased specialisation The production of larger outputs gives firms greater opportunities to apply the principles of division of labour and specialisation. In the larger firm the production process can be broken down into many more separate operations, workers can be employed on more specialised tasks and the continuous use of highly specialised equipment becomes possible. This will lead to higher productivity and lower costs per unit of output.

Indivisibility Some types of capital equipment can only be employed efficiently in units of a minimum size, and this minimum may well be too large for the small firms.

More generally the lower limit is an economic one: smaller versions of the equipment could be made but their usefulness would not justify their cost. Such indivisibility means that firms with small outputs cannot take advantage of some highly specialised equipment.

Stock economies A large plant can operate with smaller stocks in proportion to sales than the smaller firm. Variations in orders from individual customers and unexpected changes in customers demands will tend to offset each other when total sales are very large. Costs per unit will be lower as a result.

Firms economies of scale Technical A research department must be of a certain size in order to work effectively. To the small firm this minimum effective size may represent a level of expenditure too large to justify any possible returns. The large firms, the expenditure may be relatively small because the cost is spread over a large output, allowing the firm to invest more heavily in R&D. This is important in those industries where the rate of change is rapid and these sectors of the economy tend to be dominated by giant firms. Their growth leads to greater research efforts, which lead to the development of new products and the establishment of new sources of competitive advantage.

Marketing economies The larger the firm, the more likely it is to be able to buy its inputs in bulk. Bulk buying enables the large enterprise to negotiate discounts from suppliers and be able to dictate its requirements with regard to quality and delivery much more effectively than the smaller firm. By placing large orders for particular lines bulk buyers also enable suppliers to take advantage of long runs - this will reduce the cost of supplies. The large firm will be able to employ specialist buyers. Expert buyers have the knowledge and skill that enables them to buy the right materials at the right time at the right price. The selling costs per unit will generally be much lower. In selling, the larger firm can afford to employ experts whose specialised skills can give it great economic advantages. Packaging costs per unit will be lower in larger firms.

Managerial economies

The number of managers needed by a firm does not normally increase at the same rate as output if the firms output doubles this does not mean it needs twice as many managers. This lowers the cost of management per unit. Workers in small firms may have to undertake a range of tasks but as a firm grows it is more likely to be able to appoint managers to specialise in particular areas and to be able to afford to recruit experienced specialists. This can lead to better decision-making and increased efficiency. In large firms, specialist managers can be fully utilised, but it is doubtful f the smaller firm could find enough specialised work to keep them fully occupied.

Risk-bearing economies Many large firms are able to reduce the risks of trading by means of a policy of diversification. They manufacture either a variety of models of a particular product or a variety of products. A fall in demand for any one of its products may not mean serious trouble for the firm; it may well be cancelled out by a rise in demand for one or more of the other products. A small firm is likely to be specialising on one product, any fall in demand for which may have serious consequences. Small firm with a restricted market is more vulnerable to changes in market conditions. The larger firm is likely to have a diversified market structure, selling in a number of different regions or countries. In the national market, demand fluctuations between regions may offset one another; a sudden fall in demand in the home market might be balanced by a rise in the demand overseas. As a result, demand is more stable and predictable and the firm odes not need to hold as much stock for the purpose of meeting unforeseen increasing in demand this reduces stockholding costs.

Financial economies The large firm is well known and has several financial advantages. It makes them a more credit-worthy borrower. Its greater selling potential and larger assets provide the lenders with greater security and make it possible for them to provide loans at lower rates of interest than would be charged to the smaller firm. The larger firm has more access to finance and it may approach a wide variety of other financial institutions as well as taking advantage of the highly developed market in the issuing of new shares and debentures. Smaller firms will have to pay a higher risk premium to cover the great risk of bankruptcy. Government bond is when you lend money to the government. Corporate bond is when you lend to businesses.

Diseconomies of scale

Diseconomies of scale occur when a firm becomes too large and its long run unit costs increases. E.g. it may experience managerial problems such as poor labour relations. External diseconomies of scale: Rising costs that arise not from an increase in the size of the firm itself but from an increase in the size of the industry in which the firm operates.

Internal diseconomies of scale Management problems 1) Coordination: Large organisations must be subdivided into many specialist departments. As these departments multiply and grow in size, the task of coordinating their activities becomes more and more difficult. Efficiency is likely to fall as a result. 2) Control: Management consists of two basic activities - the taking of decisions and seeing that these decisions are carried out. This latter function is that of control. The large firm usually has an impressive hierarchy of authority, the problem of seeing that everyone is doing what they are supposed to be doing, and doing it well is a very difficult task. Efficiency is likely to fall as a result. 3) Communication: The transfer of information and commerce is a two-way process. Subordinates must be able to feed back their difficulties and problems. There must not only be a vertical line of communication, information must also move laterally, because one section of the firm must know what the other sections are doing. Keeping everyone informed of what is required of them and of what is happening elsewhere in the firm becomes increasingly difficult as a firm grows in size. Slower and less effective communication leads to a reduction in efficiency. 4) Motivation: The attitude of workers to management is of critical importance to the efficient operation of the enterprise, and the cultivation of a spirit of willing co-operation appears to become more and more difficult as the firm becomes larger. It is not easy to make any individual worker in a labour force of thousands feel that they are an important part of the firm and people low down the pyramid of control often lack an identification of interest with the firm and regard it with apathy and hostility. As the gap between the top and bottom grows, employees may increasingly feel alienated. Less motivated workers will be less productive and leading to a rise in unit costs. Prices of inputs As the scale of production increases, the firm will increase its demands for materials, labour, energy and transport. It may be difficult to obtain increased supplies of some of these factors. In such cases a firm attempting to increase the scale of its production may find itself bidding up the prices of some of its inputs, leading to an increase in costs per unit of output.

External economies of scale

1) Labour: The concentration of similar firms in any one area leads to the creation of a local labour force skilled in the various techniques used in the industry. Local schools or colleges may develop special courses or vocational training geared to the particular needs of the industry, thereby reducing firms training costs. 2) Disintegration: When an industry is heavily localised there is a tendency for individual firms to specialise in a single process or in the manufacture of a single component. This development allows firms collectively to achieve many of the economies of scale. Each individual firm may obtain its components and other requirements at relatively low cost because they purchase in bulk for the purpose of mass production for the whole industry. 3) Cooperation: Regional specialisation encourages cooperation and collaboration among the firms. Research centres may be established as joint ventures by the firms in heavily localised industries. Cost per unit is likely to fall as a result of such activity. 4) Specialised markets: When an industry is large enough specialised places and facilities to bring buyers and sellers into contact may be developed. External diseconomies of scale 1) Labour shortages: A shortage of labour with appropriate skills may develop so that firms in this industry may find themselves bidding up wages as they try to attract more labour. 2) Raw material prices: Increase demand for raw materials bid up prices and costs rise. 3) Land prices: If the industry is heavily localised, land for expansion will become increasingly scarce and hence more expensive both to purchase and to rent. 4) Transport costs: Transport costs may also rise because of increased congestion in the local area caused by the development of the industry. Other reasons why the LRAC curve might shift Raw materials: If the costs of raw materials required in the industry rose then there would be a shift upward in the LRAC curve. If the raw materials fell in price, the LRAC curve would shift downwards. Wage costs: A fall in the wage rates in the industry would reduce firms costs and lead to a downward shift in the LRAC curve, while a rise in wage rates would increase firms costs and cause the LRAC curve to shift upwards. Taxation: If the government imposes a tax upon industry, costs will rise, shifting the LRAC curve of each firm upwards. Technology: The LRAC curve is drawn on the assumption that the state of technology remains constant. The introduction of new technology, which is more efficient than the old, will reduce average costs and push the LRAC curve downwards.

Productive and allocative efficiency

Productive efficiency

Productive efficiency occurs if it produces at the minimum of the AC curve or MC=AC.

Only long run perfect competition achieves productive efficiency.

However, in some cases, monopoly firms can make substantial economies of scale. This results in them producing on a lower AC than the perfectly competitive firm. Thus, despite being the perfectly competitive firm being productively efficient, it is not able to achieve the same low level of AC as the monopoly. An economy is productively efficient when it is operating on its PPF.

Allocative efficiency Allocative efficiency is achieved when p=MC (welfare maximisation point) Perfect competition achieves allocative efficiency, in both short run and long run.

In industries which are natural monopolies where the minimum efficient scale is beyond the market demand curve, there are problems in pursuing a p=MC strategy. If the firm sets p=MC then it will make a loss, since AR (price) is below AC and lead to subnormal profits. Governments may not allow natural monopolies to pursuit a profit maximising strategy, they may nationalise the industry and operate a twopart tariff. One part of the tariff will set a price equal to marginal cost, the second part will be fixed access charge which will enable the industry to avoid a loss. The system was criticised as it encouraged X-inefficiency and many monopolies were privatised with regulators to prevent abuse of monopoly power.

Dynamic efficiency Dynamic efficiency occurs when resources are allocated efficiently over a period of time. A lack of dynamic efficiency occurs when firms fail to take into account the entire long term costs and benefits of an action. Where benefits are uncertain over long periods of time, firms may choose to ignore them, which may result in under-investment.

X-inefficiency X-Inefficiency decreases the minimisation of cost that occurs under the conditions of competition. It is argued that it is a necessary corollary of profit maximisation that a firm achieves X-inefficiency. However, under conditions of monopoly or oligopoly the firm is protected from competition and the firm may be under pressure to be X-inefficiency. It this is so it will lead to an upward shirt in the cost curves that would add to the adverse effects of a monopoly. Organisation knows its not making the most profit but do nothing. E.g. Keeping facilities that will keep employees on site so schools lets teachers use the gym.

Profit
Normal profit: The profit required to retain a firm in the industry and the profit that a firm could earn by using its resources. It is the minimum amount of returns the firm expect to get in order to stay in production. Supernormal profit: Profit in excess to retain a firm in the industry. If a firm does not make at least normal profit it will leave the industry. A firm which is producing where AC=AR is making only normal profit only. Subnormal profit: Profit that implies the firm is making a loss, which will induce firms to reorganise the use of their current resources which could mean leaving the industry in search for better profits elsewhere.

Strategies to increase profits In order to increase profitability a firm needs to increase revenue or cut costs. Increasing revenue will lead to a rightward shift in AR and hence MR, so increasing the profit maximisation point and price. The AR curve can be shifted rightwards y actions such as advertising. However, this is likely to incur costs, hence the increase in supernormal profit will be in reality lower.

Cutting fixed costs will result in a fall in the ATC curve from AC1 to AC2, so increasing supernormal profit from the yellow area to blue area. Cutting price would lead to a movement along the curve. Fixed costs include security, cleaning and insurance. It may be possible for a firm to contract out some non-core function to another specialist company enabling FC to be reduced. However, if existing workers have to be made redundant, there will be a short-term increase in costs before the benefit of increased supernormal profit is realised. Lower fixed costs lead to lower average costs and marginal cost is constant. Lower variable costs lead to lower average costs and lower marginal cost.

Cutting variable costs will result in a fall in the ATC curve from AC1 to AC2 and a fall from MC from MC1 to MC2, so increasing supernormal profit from the blue plus purple area to the blue plus yellow area. Variable costs are those that vary with output e.g. labour and raw materials. Firms may introduce machinery or change working practices in order to raise productivity. If machinery is purchased this will result in an initial cost, which will mean that the increase in supernormal profit is not as large as predicted in the diagram below.

Decrease in variable cost will lower average costs and lower marginal cost.

Profit maximisation
The profit maximum output is when MC=MR and results in an increase in profit. Profit is the area where MR exceeds MC.

What barriers exist to firms entering and leaving markets?

Market structure Number of characteristics that determine the market structure The size and number of firms in the market. The ease or difficulty with which these new firms might enter the market The extent to which goods in the market are similar (homogeneity) The extent of knowledge shared by firms in the market The extent to which the actions of one firm will affect another firm (interdependence)

The number of firms in an industry 1) Monopoly: It exists where there is only one supplier in the market (more than 25% of market share)

2) Oligopoly: It exists in a market dominated by a few large producers alongside a large number of small and relatively unimportant firms. They act against the publics interest. 3) Perfect competition or Monopolistic competition: There are large number of small firms, none of which are large enough to influence price. Large number of buyers and sellers and price is set by cost. Barriers to entry Market structures are affected by the ease with which new entrants can access the market. Firms that are in an industry, which is unlikely to experience many new entrants, may behave differently to those operating in an industry, which has low barriers to entry.

Product homogeneity and branding In industries such as gas and oil extraction, the product is essentially the same whoever produces it. These identical goods are known as homogenous goods. This means that no producer has a monopoly over production. Firms find it easier to maximise profits if they are able to differentiate their product by creating brand loyalty and reducing the elasticity of demand for good. This creates barriers to entry reducing the competitiveness of the market.

Knowledge Buyers and sellers are said to have perfect knowledge if they are fully informed about price and output. If one producer puts its prices up, then that producer will lose all its customers because they will buy the good from elsewhere in the industry. Perfect knowledge is when information is freely available; t is up to firms and consumers to access this. Imperfect knowledge exists where there are patents protecting a particular process. Individual firms may not be aware of all the new innovations to be introduced. A lack of information acts as a barrier to entry, preventing firms from entering the market.

Interrelationships within markets Firms may be independent of each other; the actions of one firm will have no significant impact on any other firm in the industry. If firms are interdependent then the actions of one firm will have an impact on others.

Barriers to entry Barriers to entry are obstacles that deter potential competitors from entering the industry.

Economies of scale

Existing firms may be able to make higher profits and set lower prices than new entrants. The additional profit could be spent on product development to keep them one step ahead of potential new entrants. In some industries, economies of scale are very large and this will deter a new firm from entering the market, as it is likely to produce less and have higher average costs than the existing firms, making it difficult to compete.

Limit pricing A situation where an established firm tries to forestall new entry in a situation typically where economies of scale exist. The existing firm will set a price below the AC of new entrants in order to reduce its profit. It can be practiced in order to prevent reference to a regulator or the Competition commission, or to the make the market less attractive to new entrants, particularly where the market is contestable. Limit pricing is attractive where there are economies of scale to be made, a new entrant is unlikely to be able to benefit from these initially, so setting a low price will make a new entrant unviable in the sort run and the industry unattractive.

Predatory pricing A situation where a firm is prepared to deliberately make a loss in the short run with the aim of driving a rival out of the market. In the long run this will enable the firm to raise its price more than it has previously been reduced, it can lead to a price war.

Sunk costs These are unrecoverable costs when a firm exits the industry. If a firm has high sunk costs this may discourage them from exiting the industry. Advertising is an example of a sunk cost, since its a fixed cost; it increases the AC more at lower levels of output, than higher levels of output. This can create a barrier to entry. In order to be noticed within the market place, a new entrant would have to undertake a similar level of advertising to existing firms. This gives it a significantly higher break even point than the existing firm, particularly as the new entrant is unlikely to capture the same level of market share as the existing firm.

Start-up costs Some industries such as car manufacturing require a large initial capital investment to start production. Potential competitors may find it difficult to raise this amount of capital and will be unable to enter the industry. This allows the firms in the industry to continue earning profits in the long run.

Legal barriers

This is the strongest restriction against the entry of new firms where the law operates to prevent the emergence of competing firms. Patents: The production process or the product itself may be protected by a patent. The inventor of the product or production process is given exclusive production rights for a given time period - often up to 20 years - preventing them from having the invention copied and by protecting him from the threat of competition. E.g. Medicine. Nationalism: When industries have been nationalised it has created stateowned monopolies. It is mostly government owned and had a monopoly position. Licenses: It is illegal to enter without a licence provided by the government. Licenses are often limited in supply and not granted often, it becomes very difficult for new firms to break into the industry and existing firms are able to earn long-run monopoly profits.

Marketing barriers Advertising: If existing firms spend heavily on advertising and marketing and command a high degree of consumer loyalty, it is extremely difficult for potential competitors to break into the market. New firms would have to spend a huge amount on marketing if they were to compete effectively, attract consumers and establish themselves in the industry. Such marketing could be expensive. Brand proliferation: A way for a new firm to establish themselves is to fill a market niche - a gap in the market, which is unserved by existing firms. However, existing firms can make entry more difficult through brand proliferation - giving customers an apparent abundance of choice by providing a wide range of similar products but with slightly different characteristics and closing any market niches that new entrants might exploit.

Transport costs Geographical proximity may offer a degree of protection to local firms and act as a barrier to entry against potential competitors because transport costs, journey times and the general inconvenience of travelling longer distances makes it more difficult for new firms to attract customers.

Restrictive practices A manufacturer may refuse to sell its goods to a retailer which stocks the products of a competitor firm, making it more difficult for new firms to establish themselves in the market. Alternatively, a manufacturer may refuse to supply one of its products to a retailer unless the retailer purchases its whole range of goods.

Barriers to exit

Sunk costs

Employment law: You cant fire someone due to redundancy payments and businesses tend to close down because its cheaper. Long leases: Makes closing hard because you pay rent for a long period.

Market concentration
A five firm concentration of 65% means that the largest five firms in the industry are responsible for selling 65% of all the products sold in the market. Market concentration can also be measured by calculating the percentage of output or employment accounted for by the largest firms. A high concentration ratio indicates that a few large firms dominate the industry, suggesting an oligopolistic market structure. Low concentration ratios suggest more competitive market structures such as monopolistic competition. Perfect competition describes a market where there is a high degree of competition. Always allocatively efficient and productively efficient in the long run.

Perfect competition

Conditions/Assumptions 1) There must be many buyers and sellers in the market, none of who is large enough to influence price. Buyers and sellers are price takers. The sellers accept the price as given and adjust their output to the market price. 2) There is freedom of entry and exit to the industry. Firms must be able to establish themselves in the industry quickly. Free mobility of firms ensures that the number of firms in the industry can always remain large and competition remains tough. 3) Buyers and sellers possess perfect knowledge of prices. Thus if one producer charges higher prices than its competitors for a good, consumers will buy from elsewhere in the market and demand will fall to zero. 4) Firms produce a homogenous product. All firms are producing and selling products that are accepted by buyers as identical, there are no imaginary differences such as brand names and trademarks. These ensure that no firm can increase or decrease the price of its product above or below the market price without serious effect on its sales. There are only a few industries in the world, which approximate to his model such as the foreign exchange market. There are a large number of foreign exchange dealers supplying the market, none of which is large enough to influence the exchange rate. It is relatively easy to establish a bureau-dechange and thus enter the industry, as easy to leave. A foreign exchange dealer will know the market determined exchange rate. Currencies are homogenous - US dollars are indistinguishable from other US dollars sold by another bureau-de-change.

Demand and revenue

Perfect competition assumes that there are a large number of suppliers in the market. A firm can expand output or reduce output without influencing price. A bureau de change cannot put up the exchange rate for US dollars and expect to sell anything. It may decide to lower the exchange rate, but there is no gain by doing this, as the foreign exchange dealer may sell all his output at the original higher price. The demand curve is horizontal (perfectly elastic) and is also the firms average and marginal revenue curves. If a firm sells all its output at the market price, then this price must be the average price or revenue. In addition if a firm sells an extra, it will receive the same price for each additional unit as it did for each preceding unit sold, and therefore marginal revenue will be the same as average revenue. Demand curve is perfectly elastic because the firm is a price taker, AR = MR= Price.

Short run equilibrium In perfect competition firms are profit maximisers. Firms will produce where marginal cost is equal to marginal revenue (MC=MR) The price the firm charges are determined by the market because the individual firm is too small to influence price and is a price taker. Firms in the short run are making supernormal profits, new firms will enter the industry, increasing market supply and thus reducing price. In this diagram the horizontal average revenue curve is shown to be above the average total cost at the point where MC=MR. It achieves allocative efficiency but not productive efficiency.

Short-run firm making losses The firm makes a loss at equilibrium, profit maximising where MC=MR. If production is unprofitable, firms will leave the industry, reducing marker supply and increasing price. The price charged per unit of output (p2) is lower than average total cost (p1) and hence the firm makes a loss.

When there are too many firms you get subnormal profit.

Long run If a firm were making super normal profits in the short-run, other firms would enter the industry eager to share these high profits. They would be able to do this, as there are not barriers to entry in perfect competition. The entry of new firms stimulates an increase in supply from s1 to s2 establishing a price just low enough for firms to make normal profits.

Long-run equilibrium position of a firm facing short-term super normal profits If a firm were making losses, in the long run, some firms would leave the industry, as there are no barriers to exit. As result of these departures total supply would fall from s1 to s2. Firms would continue to leave the industry until the whole industry returns to profitability. When the supply curve is at s1 the firm is making a loss. At s2 the supply curve is high enough to make normal profits.

Long-run equilibrium position of a firm in an industry facing short-term losses In the long run, competition ensures equilibrium occurs where the firm neither makes the super normal profits or losses. This means in equilibrium average cost equals average revenue.

Equilibrium for the firm In the long run in perfect competition, super-normal profits are competed away. This occurs because competitor firms are free to enter the market and have perfect knowledge of the existing firms production methods. AC=AR because no supernormal profits are made. Since products are identical, consumers are not loyal to existing suppliers. As new firms enter the market, the supply curve shifts right and market price decreases.

Supply curves In the perfectly competitive market, the supply curve of the firm is the marginal cost curve above the average variable cost in the short run and the average total cost in the long run. Marginal cost of production (i.e. the change in total cost resulting from the sale of one more unit) represents the lowest price a firm would be prepared to supply an extra unit of output. In the short run a firm will not necessarily shut down if it is making a loss. It will remain open as long as it covers the average variable cost. The firm will stop supplying if average revenue or price is less than average variable cost. In the long run, the firm will only continue to supply if all costs are covered. Therefore the minimum long run shut down point is the minimum point of the ATC curve. In the short run the firm may produce at a temporary loss if it believes that it will be profitable in the long run. If unprofitable they can shut down in which case the loss will be equal to fixed costs. It is only worth producing if variable costs are covered. Anything in excess of these variable costs contributes to fixed costs and makes the firm better off producing than not producing.

Hence the short run shut down point is the minimum point of AVC. Shut down point for firms in PC is imperfect knowledge and firms make only normal profit.

P1 shows the minimum shut down point in the long run, while p2 shows the minimum shut down price in the short run.

Evaluation of perfect competition Although perfect competition achieves productive and allocative efficiency in the long run, it is not an ideal market structure as it downs not provide the supernormal profit necessary for investment and research and development to take place. This model is useful, in that it provides a yardstick to assess how competitive other market structures are.

Monopoly
Assumptions A monopoly is assumed to: -Be the only firm in the industry. -Have high barriers to entry preventing new firms from entering the market. -Be short run profit maximisers. The legal definition of a monopoly used by the Competition Commission is when a firm has more than 25% share f the market. In the UK, gas, electricity and water supply, telecommunications and the railway track are natural monopolies because economies of scale are so large that any new entrant would find it impossible to match the costs and prices of the established firm. Some monopolies such as the water companies have considerable monopoly power because there are no good substitutes for their product. A monopoly is able to maintain its position as the sole supplier of a good or service because it is able to establish higher barriers to entry. In practice governments define monopoly as 25% market share and will investigate and regulate firms through the Competition Commission. This is necessary because of the potential abuse of monopoly power. They are productively and allocatively efficient. Revenue curves The monopolist faces a downward sloping demand curve.

The monopolist can therefore only set the level of price or output. If it wishes to sell more units it must lower price or if it wishes to increase price then it must reduce output as shown below (price maker) The monopolist cannot set both price and quantity because it cannot control demand. Price = AR as the downward-sloping demand curve shows the relationship between price per unit and quantity is the average revenue curve. If AR is falling, marginal revenue must be falling too and at a faster rate. The downward sloping demand curve shows us that if the firm wants to sell more units, it must cut its price. However, it will have to cut its price not just on the extra unit it sells but on all the unit it sells. It cannot charge a higher price to some consumers than others. The monopolists AR and MR curves

Sources of monopoly power These come largely through barriers to entry to a market. There is also the natural monopoly case where there are such substantial economies of scale that there is only room for one firm in the market.

Equilibrium output (short run and long run) A monopolist is assumed to profit maximised, it aims to achieve an output equal to the point where MC=MR. The monopolist may produce in the short run even if it is making a loss, as long as it covers its variable costs. It will close down in the short run if it cannot cover its variable costs. In the long run, a monopolist will need to cover all its costs of production and cease production if average cost is greater than average revenue in the long run. The monopolist can earn supernormal profit in the long-run because barriers to entry prevent new firms from entering the industry and competing such profits away. The diagram below shows:

-The equilibrium profit maximising level of output at q1 where MC=MR. -The monopolist s able to supply q1 at a price of p1. -Supernormal profits of the shaded area will be made. The supernormal profit per unit is the difference between the average revenue received (p1) and the average cost of c1.

The price is determined by establishing the output level where MC=MR and then identifying the average revenue for this - i.e. the monopolist sets price using the AR. The shaded are shows the supernormal profit, this remains in the long run since barriers to entry prevent new entrants joining the market and competing it away. A monopolists total revenue curve

Total revenue will rise when marginal revenue is positive. As marginal revenue falls, total revenue increases at a slower rate. Total revenue is maximised when marginal revenue is zero. When marginal revenue is negative total revenue will fall. Total revenue is zero if average revenue, the price received per unit of output, is zero too. At the top of the demand curve, demand is price elastic because a fall in price leads to a rise in revenue. At the point where marginal revenue is zero and total revenue is maximised, price elasticity of demand must be unity, since a change in price has no effect on revenue. At the bottom of the demand curve, demand must be price inelastic because a fall in price leads to a fall in revenue.

Loss making monopolist A monopolist may decide to remain operational whilst it makes a loss in the short-run as long as it is covering its variable costs and making a contribution to its fixed costs. The monopolists may feel that in the long run super-normal profits might be achieved.

Advantages and disadvantages of a monopoly Advantages Disadvantages Supernormal profit means finance for Supernormal profit means less incentive investment to maintain competitive edge to be efficient and to develop new and reserves to overcome short-term products and efforts are directed to difficulties and provide funds for research protect market dominance. and development. Monopoly power means powers to match large Monopoly power means higher prices overseas organisations. and lower output for domestic consumers. Cross-subsidisation may lead to an Monopolies may waste resources by increased range of goods or services undertaking cross-subsidisation, using available to consumer. profits from one sector to finance losses in another. Price discrimination may raise total Monopolists may undertake price revenue to a point, which allows survival discrimination to raise producer surplus of a product or service. E.g. economy class and reduce consumer surplus. flights are funded by those flying business and first class. Monopolists can take advantage of Monopolists do not produce at the most economies of scale, which means that efficient point of output (i.e. at the average costs may still be lower than the lowest point of the average cost curve) most efficient average of a small competitive firm. There are few permanent monopolies. Monopolies lead to a misallocation of Supernormal profits act as an incentive to resources by setting prices above break down the monopoly through a marginal cost, so that price is above the process of creative destruction (i.e. opportunity cost of providing the good. undermining the monopoly through product development and innovation) Monopolists avoid undesirable duplication Monopolists can be complacent and of services and a misallocation of develop inefficiencies. resources.

Nationalised industries In industries which are natural monopolies where the minimum efficient scale is beyond market demand curve, there are particular problems in pursuing a p=mc strategy. If the firm sets p=mc then it will make a loss because with a continually falling AC curve, MC is below the AC curve, therefore setting p=mc results in a loss, since AR is blow AC. P<mc and AC falls because MC is blow AC therefore it makes a loss. At p1 p=MC and since p1 is below c1 the firm is loss making. Governments may not allow natural monopolies to pursue a profit maximising strategy, they may nationalise the industry and operate a twopart tariff. One part of the tariff will set a price equal to marginal cost, the second part will be a fixed access charge which will enable the industry to avoid a loss. The system was criticised for encouraging X inefficiency and many monopolies (e.g. utilities) were privatised wit regulator appointed to prevent abuse of monopoly power and attempts made to create competition in order to encourage efficiency improvements.

Monopoly VS PC

In the diagram above, the industry transfers from PC to monopoly, consumer surplus is reduced by the area green and blue. Blue area transfers to producer surplus and becomes supernormal profit for the monopoly and the green area becomes deadweight loss.

Since the monopoly makes some EOS, it has a lower cost curve than the PC firm. Monopoly acts against the consumer interest and results into a net welfare loss for society and consumers pay in excess of MC and resources misallocated in monopolists industry. Theres a debate over whether PC or monopoly produces the greatest level of innovation. Schumpeters theory Creative Distribution argues that monopoly creates innovation and supernormal profits can fund them. Innovation is more likely under monopoly since barriers to entre mean that to enter a market firms have to innovate developing new products and methods and this would result in one monopoly replacing another. Firms in PC may innovate to keep up with competition and to take advantage of a rise in profits, however, lack of barriers to entry means any benefit from innovation is short run. Monopolies are likely to have the funds available to spend on research and development, since there are no barriers to entry; monopoly profits resulting from innovation are protected. However, they may choose not to innovate if they see no competition.

In the diagram above, due to substantial economies of scale it transfers from perfect competition to monopoly and there is a net welfare gain. The consumer gains the yellow area as price decreases and increase in consumer surplus. The blue area is supernormal profits as it is able to produce at a lower AC due to EOS.

In the diagram above, the industry transfers from PC to monopoly and theres a loss of consumer surplus shown by the purple plus green area. The green area is deadweight loss and the purple area is producer surplus. The blue area is supernormal profit. Since the blue area is greater than the green area there is a net welfare gain.

However, monopoly results in X inefficiency -failure to minimise costs/organisational slack and creating an efficiency loss. However, since the welfare gain goes to the producer at the expense of the consumer, this might not be considered socially desirable.

Other costs of monopoly Resource cost of obtaining and maintaining a monopoly firm. Some monopolies are created by the government. In order to win a franchise; firms will devote resources to the bid, it could be argued that these are wasted. Money might be spent on hospitality but if sold to highest bidder, resources would not be diverted to hospitality and money might be used in a more productive way. However, sale of TV franchises demonstrates that companies paying the highest figures may have to reduce programming costs and quality of programming may suffer, which is not in the public interest.

The conditions necessary for price discrimination in monopoly Definition Price discrimination occurs when a firm charges different prices to different consumer groups for the same product. The price differential is not associated with different costs of production. E.g. children pay less in the cinema for the same service.

Conditions required for price discrimination to work 1) There must be different price elasticity of demand for the product from each group of consumers - This allows the firm to extract consumer surplus by varying the price leading to additional revenue and profit. Lower the price where ped is elastic so TR increases and gain in consumer surplus. Raise the price here ped is inelastic so TR increases so loss of consumer surplus. 2) Firms must be able to prevent market seepage (arbitrage) - Consumers paying the lower price have an opportunity to re-sell to those who would be charged a higher price. Its easier in the provision of services rather than goods by the nature of the product. E.g. Rail companies employ inspectors to prevent seepage between off peak and peak travellers. 3) The costs of separating the market must be less than the additional revenue gained and selling to different sub groups or market segments must not be prohibitive - Monopolist must have control over the sale of the product with price setting power. First-degree discrimination The firm separates the whole market into each individual consumer and charges them the price they are willing to pay (indicated by the demand curve) Firms will sell an output up to the point where AR=MC. Beyond this point the price consumers are willing to pay is less than the marginal cost of production making additional output unviable.

Perfect PD allows the monopolist to extract every last bit of consumer surplus from each buyer and consumer is charged a price exactly equal to what hes willing to pay. Every consumer is charged a different price and the maximum they are willing to pay. Examples of first degree PD include bargaining in street markets and antique fairs. First degree PD can be beneficial in enabling a firm to make a profit where none was available without PD. This can enable a good or service to be produced, which is valued by consumers. Firms only lower the price to the last customer when PD.

Second-degree price discrimination This type of price discrimination is based on the amount sold. This is often seen in industrial processes, where a firm can be rewarded for the quantity of a product that it buys.

Third degree price discrimination Occur when the monopolist groups the customers into different markets and charges different prices to different markets but the same price for all within the same market. The monopolist is able to divide his customers into 2 or more groups, charging a different price to each group. A higher price is charged in the market with less elastic demand. Assuming a constant marginal cost for supplying to each group of consumers, the firm aims to charge a profit maximising price to each. Consumers with an inelastic demand for the product will pay a higher price than those with an elastic demand. The elasticity of demand reflects the willingness to pay for the good or service. Diagrams demonstrate that inelastic market is charged more than elastic market.

Price discrimination for producers The most profitable system of discriminatory prices will provide higher total revenues to the firm than the profit maximising single price, leading to higher profits. PD enables larger output and internal EOS to be reaped, leading to lower AC and higher profits eventually.

Is price discrimination in the interests of consumers? Consumer surplus is reduced in most cases representing a loss of consumer welfare. In the third degree in an elastic market some is removed. All is removed in the first degree. Some consumers who can buy the product at a lower price may benefit. Previously they may have been excluded from consuming it. Some markets where the price is reduced will get additional consumer surplus. Price is greater than marginal cost and therefore firms are not achieving allocative efficiency (p=mc) - not in the interest of consumers. Price discrimination is in the interest of firms who achieve higher profits. Producer surplus is greater so societys welfare rise and at the expense of consumers. Allow firms to cross subsidise loss-making activities that have important social benefits. Poor are able to consume the good for which consumption is impossible at higher uniform prices. The group of consumers with high demand elasticity are able to enjoy the good at lower price whilst those with low demand elasticity do not mind paying a higher price.

Monopolistic competition
Imperfect competition Perfect competition assumes that there are many small firms and all goods are homogenous, and in monopoly it is assumed there is only one supplier. Competition is imperfect because firms sell products, which are not homogenous. E.g. Toothpaste market and Indian restaurants.

Assumptions 1) There are a large number of small firms. 2) There are low barriers to entry or exit. 3) Firms produce similar but differentiated products. Producers are similar but differentiated in terms of packaging, colour, design, specification, marketing or price from rival products. This results in brand loyalty and downwards-sloping demand curve. Supernormal profits are competed away in the long run. However, advertising can create differentiation is wasteful and leads to higher average cost than necessary. However, the need to compete may

result in less X inefficiency than under monopoly. Inefficiency is when the firm knows about it but doesnt do anything about it. The downward sloping demand curve Firms producing a product, which is slightly different from their rivals, will have a certain amount of market power. They will be able to raise price without losing all of their customers to those firms who have maintained stable prices. Therefore the firms demand curve is downward sloping. It is not a price-taker because there are a large number of firms producing close substitutes; its market power is likely to be relatively weak.

Short run The shaded area shows super normal profit - this will disappear in the long run as firms are free to enter and exit the market, no barriers to entry and perfect knowledge. It is neither productive nor allocative efficient. (P>mc) Not producing on the minimum point of the AC curve.

Long run The firm will produce where MC=MR so as to profit maximise. In the diagram above, this means that it will produce at an output level of Q1. It will charge a price based on its demand or average revenue curve, P1. In the long run the firm will not be able to obtain supernormal profits, because new firms will enter the industry if they see profits to be made exploiting the lack of barriers to entry. The entry of new firms will increase supply, shifting the average revenue curve downwards to the point where AR=AC. If the firm were making a loss, firms would leave the industry, reducing supply and shifting the AR curve upwards again to a point where average revenue is equal to average cost. Therefore in the long run a monopolistically competitive fir can make neither supernormal profits nor losses. Not productive or allocative efficient.

1) 2) 3) 4) 5)

Draw AC. Draw AR (tangent) Mark off P and Q. Draw MR. MC must pass through where Q=MR and minimum of PC.

PC VC MC Differentiation results in smaller quantity produced and slightly higher AR.

Oligopoly
An industry dominated by a few large producers supplying either an identical or differentiated product. There is a high concentration ratio and firms are interdependent. The small number of firms ensures interdependence, where each firm is aware that its future prospects depend not only on its own policies but also those of its rivals. The industry may be competitive or collusive. They keep prices stable - they know that the actions of one firm will impact on the other firms in the industry, in other words they are interdependent. If one firm were to raise its prices then others would not follow and because the goods traded are similar, customers will move to the lower cost option. If a firm were to lower prices then other firms would follow suit and a price war would result, with no real gain for any of the firms in the industry.

Instead, oligopoly firms will tend to work together through collusive agreements, whether they are tacit or overt or engage in non-price competition. Collusion is where firms agree on prices, market share, output and advertising expenditure. Non-price competition can take the form of advertising, issuing of loyalty cards, branding, packaging, and other measures to reduce the closeness of substitutes.

P1 is the stable market price. Above P1, the firm believes that if it raises its price, the competitors will not follow suit and it will lose market share; therefore demand is price elastic above p1. At prices below p1 the firm believes that lowering its prices will result in competitor firms lowering their prices; therefore demand is price inelastic below p1. This results in the kink in the AR curve and the subsequent hole in the MR curve. Any MC curve that passes through the hole in the MR is compatible with q1, p1 as profit maximisation.

Non-price competition (competitive oligopoly) Oligopolies demonstrate the features of a stable market price (kinked demand curve) and firms compete in ways other than by price. They wish to avoid a damaging price war and do not reduce prices to capture market share for fear or sparking a price war, which can result in a loss of revenue for all participants (although gains for the consumer) There are many ways of increasing sales through non-price competitiveness including: advertising and marketing, extended opening hours, extended guarantees on the product, loyalty cards, home delivery or discounted petrol.

Cartels (collusive oligopoly) Oligopolies have the incentive to collude to behave as a monopoly, since collusion reduces uncertainty and risk. It will include behaviour such as agreeing production levels, in order to maximise prices and profits for the cartel as a whole. A formal collusive agreement s called a cartel, it refers to a group of firms that agree to coordinate their production and pricing decisions so that they act as a single firm to earn monopoly profits.

For a cartel to be successful, producers must control supply to maintain an artificially high price. Collusion is easier when there are a relatively small number of producers in the market, and a large number of customers, market demand is not too variable, possible to prevent new firms from entering the industry and the individuals firms output can be monitored easily by the cartel. The cartel will not wants its members to be undercut, and risk losing market share. To maintain the cartel, members should have similar costs, otherwise some will benefit more than others from the price set, and firms must have similar objectives to bind them together and must not cheat. A cartel provides an incentive to cheat for individual members, particularly if they feel that their output quotas have been set too low. It is in the interests of an individual firm to break the agreed quota and over-produce. Since the other members will have restricted output, any one members additional output will not depress market price to its previous level, the cheating member will benefit from a higher price and higher output, thus receiving substantially increased profits and greater market share. Once one firm over producers, the market prices start to fall, all firms have the incentive to break the agreement. In these circumstances its hard to hold the cartel together. Cartels are unstable, often illegal and governments do not like markets this way. Cartels always collapse and there are a number of pressures leading to this. It is in the short-term interest of members to cheat, tension is created during economic downturn when demand falls. Other problems include the entry of non-cartel member firms into the industry reducing the percentage of the market controlled by the cartel, discovery of price fixing agreements by governments or regulators. E.g. OPEC, European steel producers and International Coffee Agreement (ICA)

Collusive oligopoly Firms prefer to collude because: It reduces uncertainty due to interdependent firms in the market, it avoids the high costs of non-price competition, it avoids the situation of price cutting that leads to less revenue for all and profits would be even higher compared to the competitive situation. Firms collude by agreeing to limit competition among them. They may fix prices, set output quotas and agree on market share. Collusion between firms is easier if: Their production and average costs are similar, they produce similar products and can easily agree on price, there is a dominant firm and there is no government regulation prohibiting collusion.

Price leadership in oligopoly (tacit collusion)

When one firm has a dominant position in the market, it may take the lead in price setting. Firms with a lower market share simply adopt the price set by the leader. This is a type of tacit collusion where firms in the market observe each others behaviour closely and do not compete on price, even if they do not communicate with each other. Firms tacitly collude by watching each others prices to avoid price wards.

Game theory Can be used by economists to predict how firms will react in a number of given scenarios. It is used when dealing with oligopoly to explain why firms may collude and why they may later decide to abandon any agreement to collude. Marias plea Juans plea Innocent Maria Juan Guilty Maria Juan Innocent Light sentence Maria Light sentence Juan Severe sentenceMaria Go free Juan Guilty Go free Severe sentence Medium sentence Medium sentence

Prisoners dilemma

This example explains why oligopolistic firms would prefer to collude rather than compete, also they are highly interdependent on each other - they consider the competitive response of the other firms to their actions before deciding on the course of action to undertake. It illustrates that different strategies can be in the best interest of the firm depending on whether it colludes or competes. Nash equilibrium - Occurs when each players chosen strategy maximise pay-offs given the other players choice, so that no player has an incentive to alter behaviour. Assumptions: -Model assumes a zero sum game (a winner and loser) -Prisoners have been kept separate and do not know what each is doing, but they know the outcome of each action.

What should they do? Confess - If one of them confesses they should get a light sentence, but as they cannot trust each other and cant be sure that the other party has not confessed (which would result in a severe sentence for each prisoner who did not confess), they would act selfishly therefore both confessing to get the best solution for themselves. They tend to both confess. Not confess - If they trust each other and be sure of each others response this would be the best option. By not confessing both prisoners would get a light sentence. Maximax - maximising the maximum benefit for the individual would mean that they should confess and get a light sentence, but if one could be trusted not to confess, both will get a light sentence.

What determines the behaviour of firms?

Maximin - Minimum benefit where the prisoners will tend to because they cant trust each other and get a severe sentence. Dominant strategy - Same policy is suggested by different strategies. This is a dominant strategy game because both strategies encourage a cut in price. Nash equilibrium - Position resulting from everyone making his or her optimal decision.

Behaviour of firms in different market structures The structure-conduct performance model argues that oligopoly and monopoly charge high prices and results in supernormal profits, basic market conditions determines the structure of a market which in turn will determine firm conduct and performance. Markets that are highly concentrated are able to set high prices or engage in anti competitive practices that result in supernormal profits and efficiency losses. However, the model has been criticised by the contestable market approach.

1) Objectives: We assume that firms will seek to profit maximise, in monopoly and oligopoly they may pursue other objectives. 2) Non-price competition: Firms in oligopolistic competition may engage in non-price competition that is a key feature of oligopoly, where stable prices encourage non-price competition, often through advertising. They may engage in predatory pricing where they put price below the cost to drive the competitors out of the market. Limit pricing is when they price to restrict profit to restrict firms entering. 3) Interdependence: They take into account the likely reactions of others when deciding on pricing and output. In PC and MC, firms are independent. Only in oligopoly this occurs. 4) Collusion: May occur in oligopoly where firms cooperate to restrict output and raise prices. In a monopoly collusion is not possible but defined as a 25% market share, it can occur. Competition is a feature of PC and MC. Assessing the performance of firms in different market structures 1) Price: PC will deliver the lowest possible average costs (productive efficiency), where significant economies of scale exist; monopoly may in fact provide a lower price to the consumer, proving the most efficiency. This can be linked with a discussion of consumer surplus, which will be greatest where price is lowest. 2) Profit levels: In PC and MC, firms make only normal profit in the LR, while in oligopoly and monopoly supernormal profit can be made in the LR. However, high levels of sunk costs can reduce profits significantly in the long run (e.g. advertising and infrastructure costs) Sunk costs may have to be covered in the long run. 3) Efficiency: Firms in PC achieve productive and allocative efficiency in the long run. However, productive and allocative efficiency and example of static efficiency is efficiency at a particular point in time. Dynamic efficiency is

concerned with whether resources are used efficiently over time. Innovation may result in falling AC and monopolies may encourage productive efficiency over time. Monopoly can be dynamic efficiency if it drives its AC down. 4) Innovation: No agreement on which market structure delivers innovation most effectively, Schumpeter argues it is monopoly. 5) Consumer choice: In PC it offers the consumers the greatest choice, while monopoly offers the least. However, since all products are identical in PC, it is not much of a choice. Oligopoly may provide considerable choices. 6) Perfect knowledge: PC provides perfect knowledge and consumers can make informed choices. In other market structures they may be the victims of persuasive advertising, and make less rational purchasing decisions that offer them lower levels of benefit or satisfaction.

Monopsony
Monopsony occurs when there is a single buyer of a good. The buyer may be able to exert substantial influence over the suppliers of the good when drawing up contracts on the price and quality of goods. This power may be especially strong when the sellers are relatively small and numerous. E.g. In supermarkets the sheer buying power of the large chains would leave the relatively fragmented suppliers in a weak bargaining position, the supermarkets would then be able to keep their costs down by using their bargaining strength. In the labour markets monopsony would occur where there are a large number of employees, but one dominant employer whose employment decisions directly affect the wage rate. The dominant employer is the monopsonist. This situation is most likely to occur where a large single plant like a steel mill. When labour is mobile, the number of potential employers increases and the labour market ceases to be monopsonistic.

The labour demand curve (DL) shows the firms marginal revenue product of labour (MRP) at each level of employment. The labour market supply curve (SL) shows the quantity of labour supplied at each wage rate. In order to attract an extra unit of labour the firm must offer a higher wage rate to all units of labour employed. The marginal cost of employing an

additional unit of labour (MCL) will be greater than the wage rate at each level of employment. Monopsony employers can keep wage levels down and the quantity employed down, as its not a competitive market. Monopsonist employment in a government is healthcare or education.

Competition
Contestable markets If a market is contestable, the firms within the industry will behave in a competitive way. A contestable market is when it has low sunk costs and low barriers to enter. This means new firms can quickly enter an industry when they see supernormal profits being made and exploit these before leaving the industry. This is known as hit and run profit. It will be very competitive regardless of how many firms are in the industry. The firms in the industry will take care not to price themselves out of the market. Close regulation of monopoly firms in contestable markets are required to ensure appropriate competition. Lack of regulation may result in predatory pricing. Firms could offer favourable terms to suppliers who did not handle the products of competitors. High levels of advertising and publicity or research and development may deter new entrants since it adds significantly to fixed costs.

Contestability When an entrant has access to all production techniques available to the incumbents, is not prohibited from wooing the incumbents customers, and entry decisions can be reversed without cost. Three conditions: -Perfect information and the right to use the best available technology. -Freedom to advertise and being legally free to enter the market. -Absence of sunk costs. Sunk costs are those which a firm incurs in setting up and running a business which are irrecoverable to the owners of the firm should it decide to leave that particular industry or go banking. (E.g. advertising and equipment)

If an industry is contestable than incumbent firms may be forced to act as if they are in competition and be satisfied with making only normal profits because of the threat of hit and run tactics. Any firm making supernormal profits would be opening up opportunities for new entrants to come into the market, undercut existing prices and take the profit for themselves.

Evaluating the theory of contestable markets No market is perfectly contestable (i.e. zero sunk costs) - the degree of contestability. To test the theory (i.e. the absence of sunk costs restrains the activities of incumbent monopolists) would require a great deal of information about the cost structure of the incumbents. Its not usually available. Controversy about whether the threat of hit and run competition is sufficient to make incumbent firms go weak at the knees. Finding out cost structures of incumbent firms is difficult because the information is commercially sensitive - so difficult to judge whether the firm is pricing at competitive levels or not.

Diagram for contestable markets

If the firm produces at Q1 and prices at P1 it will make supernormal profits and new entrants will be attracted in. Contestable market is when AC=AR. Because of the costless entry and exit new firms will arrive and take away the incumbent firms market share unless price is reduced to where the firm is making normal profit (P2) In terms of the objectives of firms, contestability may force the incumbent away from profit maximising to a sales maximising strategy more in line with the interests of consumers. The degree of contestability should determine the extent of the price reduction.

Factors to consider when assessing the degree of contestability within a market

Technological change: New entrants may be committed to capital expenditure based on out-dated technology. This is acute in highly capitalintensive industries. Natural monopoly aspects: Some industries have high levels of nonrecoupable and non-relocatable infrastructure expenditure (e.g. sunk costs) High levels of capital expenditure are not in themselves proof of low contestability. High level of advertising expenditure and branding: If the market has very strong bands than a new entrant would have to spend heavily on marketing their new product. If the product fails such expenditure cannot be clawed back. This would include advertising (sunk cost) and the design of packaging. Limit pricing: If the incumbent firms establish a reputation for limit pricing then potential new entrants may feel they are guaranteed losses should they risk entering the industry. Information asymmetry: The theory that the firm tends to assume that there is symmetrical information available to both potential new entrants and to incumbents. However, there may in realist be an imbalance. There is an invisible barrier to entry, if the incumbent has better information about the way the industry works than the potential new entrant will take expensive time for new entrants to acquire this know-how. Possession of exclusive rights to raw materials or distribution facilities: Potential new entrant will find it difficult to acquire raw materials necessary to begin producing. Investment costs: Specialised equipment may be difficult to sell second hand and if the new firms investments can be sold on, they will often depreciate soon after being purchased. Particularly in high tech industries. Reputation of the firm: Potential entrants may fear that the incumbent firm will adopt ruthless pricing or non-pricing strategies.

Government intervention to maintain competition in markets

Competition policy Competition policy refers to those measures used by government to promote competition and protect consumers against anti-competitive practices. The classical view is that perfect competition is the optimal market structure since it leads to productive and allocative efficiency and maximum consumer choice. Any movement away from this optimum results in a loss of welfare.

Monopoly under producers and over prices resulting in monopoly profits and deadweight loss. This results in a mis-allocation of resources. There is a further likelihood of misallocation of monopolies become complacent leading to X inefficiency and a failure to innovate. Competition policy should prevent the build up of monopoly power by preventing mergers and acquisitions. Collusion needs to be prevented, since this enables firms to avoid competition with one another. In addition, existing monopolies may need to be broken up.

Criticism of Classical View Baumol agreed that as far as economic efficiency is concerned, it is not the market structure that matters but rather the contestability of the market in question. A monopoly may be forced to keep prices low and make only normal profits if there is no sunk costs preventing hit and run entrants. By this analysis, competition policy should look at the factors determining contestability rather than market concentration ratios. The Classical View assumes that perfect competition is the ideal, which is unlikely. Even in small scale production there may be informational asymmetry. Product differentiation is the norm, which casts doubt on the starting point of the classical analysis. Schumpeter referred to creative destruction, whereby large firms may drive out small ones. A ban on mergers would remove one of the driving forces of efficiency and change. Supernormal profits provides the funds for research and development and hence innovation. Restricting the growth of firms may end up by restricting consumer choice. The move from small to large firms is likely to result in economies of scale, which as we have already demonstrated, results in welfare gain. Monopolies may even charge lower prices and produce more than a perfectly competitive firm in industries where substantial economies of scale are available. Preventing mergers may create a welfare loss. Branding has enabled consumer recognition of products and can help to overcome problems of informational asymmetry. The quality may be only a standard quality but it is a recognisable one. Significant expenditure on advertising and research and development can help maintain the newness of the brand. Competition policy in the UK and EU

Taxation on supernormal profits - Effective in redistributing income but it does not change a monopolys price and output decisions, therefore doesnt improve allocative efficiency. Subsidies to reduce price and increase output - Unlikely in practice and may distort international competition. Privatisation to increase competitive pressures and reduce prices. Reduce barriers to entry and make the market more contestable. Regulation - E.g. price controls, prevention of mergers, making anticompetitive behaviour illegal, preventing misleading adverts and giving consumers minimum rights.

UK policy The 1998 Competition Act and 2002 Enterprise Act provide the regulatory framework allowing regulators to act against anti-competitive practice. Operating a cartel is now a criminal offence. The Office of Fair Trading (OFT) investigates competition concerns and may refer matters to the Competition Commission for more detailed investigation. The CC conducts in-depth inquiries into mergers, markets and the regulation of major regulated industries such as water, electricity and gas. Every inquiry is undertaken in response to a request by the OFT. Firms may appeal an OFT judgement to the CC. the CC will then investigate and report to the DTI. If the OFT ruling is upheld the firm must comply or risk being fined up to 10% of its annual turnover. The CC has also has the power to force a firm to sell some of its assets or to jail directors for up to 5 years.

Mergers policy The CC conducts inquiries into mergers between firms in response to requests from the OFT. This will take place if the merger of two firms will result in a market share greater than 25% or it meets the turnover test of a combined turnover of 70 million or more. At this size a firm may display a monopoly characteristic and be able to dominate the market. The Enterprise Act 2002 introduced new regulations for assessing whether a merger should be allowed to proceed. In allowing most mergers the Commission must determine whether the merger will impact adversely on competition, in other words if it prevents, restricts or distorts competition then the merger is likely to be blocked. The OFT has the preliminary responsibility for investigating a proposed merger (25% or more market share) and has the power to impose conditions or refer the merger to the CC for full investigation. The first step of any investigation is to determine the relevant market and potential substitutes. Concentration ratios can then be examined.

Topical examples In 2006 the OFT investigation of credit card charges decided that charges for exceeding a credit limit or making a late payment were too high. Following discussion with credit card providers, the ceiling fee is now 12.

Bristol International Airport wanted to take over the Exeter and Devon Airport. The OFT felt that they were in competition with each other and referred the merger to the CC, they were concerned a reduction in competition might act against the interests of airlines and passengers. The bid was withdrawn. Benefits and costs of mergers Benefits Costs Enjoy economies of scale - this might include Increased market power leading to lower rationalisation, synergies, buying economies output and higher prices, the possibility of and economies of scope that may lead price discrimination and the increased to lower prices. likelihood of collusive practices. Lower quality product. Greater expenditure on investment, and Newly merged firm may be able to use its on R&D thus allowing innovation and up to date resulting market power to increase barriers products for consumers. to entry into the industry. Market power inside the UK may Any increase in price will produce be necessary to defend businesses from the allocative inefficiency. Restrictions in threat of multinational companies. output will be technically inefficient. Greater ability to compete internationally. Fewer firms may mean less variety of products available to consumers. Restrictive practices policy (cartels) Restrictive prices - E.g. price fixing, agreements to limit production or coordinate investment, collusive tendering, sharing information to limit competition, boycotting certain suppliers or distributors, agreements to divide the market are prohibited. The OFT will monitor firms to identify illegal activities, and has the power to enter businesses and search for evidence. The punishment for the operation of a cartel can include imprisonment for up to a maximum of gives years and/or a fine. Fines are up to 10% of turnover for each year in which the firm engaged in restrictive practices (3 year maximum)

Monopoly policy Dominant firms (normally over 40% market share) who behave in an anticompetitive way or abuse their power can be fined up to 10% of turnover.

EU competition policy EU policy prohibits restrictive practices such as price fixing, collusion, and the abuse of a dominant position in the market, including that arising from mergers e.g. restricting output to increase prices and discriminating against some customers. Recent fines issued by the ECC include: -April 2007 Dutch brewers: Heineken, Grolsch and Bavaria for sharing prices. -February 2007 European escalator and lift manufacturers: Kone, Otis, Schindler and Thyseen Krup for price fixing.

USA competition policy In the USA the Antitrust Commission seeks to promote competition in the market places. Individuals who undertake anti-competitive behaviour in the US can be fined up to $1 m and jailed for a maximum of 10 years. In addition, firms may be fined up to $100 m for each violation.

Reasons for regulation Monopoly power means that the industry is inefficient. Externalities mean that allowing the market outcome results in inefficiency. Equity is not provided by the market outcome e.g. services like water is essential. Many of the public utilities are natural monopolies - they have regulatory bodies whose purpose is to stop exploitation of a monopoly position. The regulators role is to mimic competition and force the firm to consider the prices charged and the quality of service provided. The regulator will also try to encourage actual competition by reducing the barriers to entry.

Methods for regulation The government appoints a regulator as a surrogate to competition to set price and maintain quality. Since competition has been established in the telecoms, gas and electricity industries, water are the only previously state owned industry to have prices set by the regulator. The regulator will examine issues beyond prices such as quality of service and most demand reports from the companies regarding the standard of service being provided. The UK operates a discretionary system of regulation, which means that problems are negotiated between the regulator and the firm rather than adhering to strict rules. This gives flexibility and industry specific decisions.

Price capping Firms are limited to price increases of the rate of inflation minus an amount defined by the regulator. Assuming X to be positive, this will give price rises, which are blow the rate of inflation. This was designed to force efficiency gains some of which would be passed onto the consumer. Some industries e.g. water have to put a lot in to capital investment and thus regulators allow them to price increase above inflation (RPI+K)

RPI-X This takes the RPI and subtracts a factor X determined by the regulator. X represents the efficiency gain that the regulator has determined can reasonably be achieved by the firm. BT and BG were once regulated in this way.

RPI+K The regulator decides on a K factor in order to enable the firm to raise the revenue necessary for additional capital spending. In the water industry the K factor is different for every firm, depending on how much each needs to spend to maintain and improve their quality of service.

Evaluation for price capping Regulation relies on the privatised firms actually providing the information required by the regulator. Regulators often have fewer resources than the firm they are trying to regulate and often find it difficult to obtain accurate information on costs. The problem of asymmetric information makes the regulators job difficult, and can result in an inappropriate value of X being set. If regulators identify too closely with the firm rather than the consumer regulatory capture can result. They would be less strict on the firm. X may be set too low resulting in excessive profits. It may not provide an incentive for greater efficiency if the regulator keeps raising X rather than leaving it stable for a number of years. X is normally set for 4-5 years. If the period is too short, firms face uncertainty that may discourage investment. If the period is too long and X has not been set aggressively enough then shareholders rather than consumers benefit from efficiency gains. The regulator may have too much power - they are unelected and may not represent the views of the public. Frequent changing of regulations encourages short-termism by firms. Too much time wasted in the battle of wits between regulators and companies. If the value of X is set too high, it can lead to under investment in the industry. The low rate of return will discourage firms from investing in new technology or greater capacity. In addition, the firm may seek cost savings, which are undesirable such as cutting expenditure on maintenance or safety.

Rate of return It allows a firm to make a particular level of profit based on their capital before the remainder of the profit is taxed at 100%. Unlike the price capping system, it means that there is no incentive to make efficiency gains that increase profits. Firms are not rewarded for their success but are penalised for it and encouraged to make limited profit. There is an incentive to overstate the value of their capital to ensure that they can increase the rate of return on

their investment, in effect increasing their profits. The system may result in X-inefficiency. Performance targets The regulator can set performance targets that it will monitor. They may be based on improvements in the quality of service or reductions in the number of customer complaints. This may be supported by a system of fines if the firm does not meet the target set. This has been used by the regulator to monitor the performance of the train operating companies in the UK and to help determine future price increases.

Yardstick competition The regulator can use the performance of different firms in the industry to set price and customer service standards. Yardstick competition is used when the firms are regionally separate and there may be no direct competition. The best performing firms set the standard and are used as a yardstick for the rest of the industry when a price regime is formulated. In theory its possible for the regulator to use yardstick competition to maximise efficiency and eliminate supernormal profits when cost changes across firms are analysed. However, the precise way in which comparative cost information is used in price reviews by regulators (e.g. OFWAT) is often unclear and sometimes comparisons appear subjective.

Effects of regulation in practice To what extend have prices been reduced in real terms? Has the price cap increased or reduced competition? Has regulation allowed supernormal profits and have firms made at least normal profit? What have been the effects on investment? Have there been consequences for quality of service? What have been the employment and consequences of regulation?

Costs of competition policy and regulation Benefits Costs Markets work more efficiently (both Slow and may not prevent anti-competitive action dynamic and static efficiency) as result of until too late e.g. predatory pricing. competition. Fines and penalties and legislation act as Compliance costs for global firms to try to a deterrent to uncompetitive behaviour. please all regulators in all markets they operate. Give tax advantages and lower corporation Restrictive practices can be drafted to avoid tax in some areas. laws - regulation not effective. New powers make more rapid action Loss of competitive advantage of some UK possible to seek out abuses and prevent firms and loss of jobs - competition creates

them. losers as well as winners. Prohibition approach clear and exemptions Increased costs to producer, less monopoly possible. power and reduced EOS. Recent reforms to laws are reducing Less R&D or investment if firms lose compliance costs. monopoly profits. Encouraging the growth of small firms to Public interest a vague term, uncertainty as join the market. to whether action will be successful. Lowering the barriers to entry. Costs of regulation and legal action. Greater sovereignty and choice. Inappropriate judgements can be made resulting in loss of consumer welfare. Public Private Partnerships (PPP) Successive governments have wished to increase the role of the private sector in activities previously the sole preserve of the public sector, because they believe that this is conducive to the efficiency use of economic resources. E.g. privatisation - contracting out and competitive tendering. The name given to a range of initiatives that involve the private sector in the operation of public services, the PFI is the most widely used initiative. A PPP is an arrangement by which a government service or private business venture is funded and operated through a partnership of government and the private sector. Private Finance Initiative (PFI) The PFI was launched as a way of trying to increase the involvement of the private sector in the provision of public services. It was seen as a way of funding expensive infrastructure developments without running up debts. Rather than borrowing to fund new projects, the government entered into a long-term leasing agreement with private contractors. The government believes that private sector finance and management expertise, combined with the profit incentive, enables the private sector to produce services more cheaply than the public sector can. Under a PFI, companies borrow the cash to build and run projects for up to 60 years. The public sectors specifies the services that it requires and then invites tenders from the private sector to design, build, finance and operate the scheme. PFI costs are fixed, with big penalties for terminating contracts; the effect of these regional debts is to increase the risk of services being closed at nearby hospitals built with public money. Hospitals retained doctors and nurses by spending less on building maintenance. However, it is still paid for through the public purse as its more expensive than public capital as the country will pay more in the long run. If the private sector can achieve significant cost savings, then it should be possible for them to achieve a healthy return on its investment and still provide a value for money service to the public sector.

However, if the system is to offer value for money, then the public sector must be able to purchase services more cheaply than it could produce them itself and the services must be of an acceptable quality. However, there are high administration and costs, added to the fact that it is more expensive for the private sector to borrow than for the public sector. Also, there is a concern that the private sector may have less incentive to give due attention to healthy and safety issues compared to the public sector. There may be a concern that private firms will be tempted to sacrifice safety or service standards in the quest for profit. There are worries that private firms will reduce the quality of buildings and series in order to reduce cost.

Examples of PFI Croydon Tramlink in South London - the local authority cannot put new trams on the track or change the timetable without renegotiating another PFI contract. University Hospital Coventry where the NHS trust was forced to borrow money in order to make the first 54 m payment owed to the PFI contractor. High cost of hospitals built under PFI is forcing service cuts at neighbouring hospitals built with public money. In 2005 the hospital trust in Coventry was anticipating a deficit of 13 m due to PFI. They were require shutting one ward, removing 8 beds and shortening the opening hours of the surgical assessment unit and cut 116 jobs.

Why the government continues with PFI despite costs Enables projects such as hospitals and schools. Private sector is seen to be more efficient. Defers payments for expensive projects. Paying rents or by leasing. Lowering borrowing costs.