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Class Reading
• Remainder Part B: 118- 176
• Part C: 117- 217
• Knowing the diagrams in this section is very important
• Book: CIMA (certificate 4) Fundamentals of Business
Economics
-Chapter 6a: 118-131
-Chapter 6b: 132-157
-Chapter 7: 158-176
-Chapter 8a:177-191
-Chapter 8b:192- 217
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Market Structures- Perfect Competition & Monopoly
The firm’s output decision
• Total revenue (TR): total proceeds of selling a given
quantity of output
• Average revenue (AR): price per unit
• Marginal revenue (MR): the additional to total revenue from
the sale of one extra unit
A price maker can only sell a finite amount at
$
$ per unit
A price taker can sell all its output at the same
price. MR & AR are constant & equal
any given price. To sell more, the price must
be reduced. This means that MR is always
less than AR (to sell one more unit, the price of
all units must fall) MR may become negative
P
AR=MR
MR
Sales
AR= demand
Sales
3
• Both the price taker and the price maker maximise profit at
MC=MR, MC=MR is the profit maximisation position
At outputs less than Q the extra cost of
making an extra unit is less than the extra
revenue from selling it
Price Taker
MC
$ per
Unit
At outputs greater than Q the extra cost of
making an extra unit exceeds the revenue from
selling it
Price
Maker
MC
$
Loss
Profit
Profit
Loss
MR
Q
Sales
Q
Sales
4
Perfect Competition
• Characteristics of the perfectly competitive market
– Many buyers and sellers; each firm is a price taker, unable to influence
market price
– Buyers and sellers act rationally and have the same, perfect
information
– The product is homogenous (common throughout)
– There is free entry and exit for firms
– There are no transport or information costs
– Normal profits are earned in the long run
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• In the short run, the number of firms is fixed. Firms may
make losses or supernormal profits by operating at the
profit maximising level of output, ie. Where MC=MR
Price
$
MC
Price
$
MC
AC
AC
D=AR=MR
Super
Normal
Profit
Loss
P Max
Output
D=AR=MR
P Max
Output
6
• In the long run, because there are no barriers to entry or
exit, super normal profit is competed away and lossmaking firms leave the industry. The remaining forms can
only make normal profit and will operate where
MC=MR=AC=AR=price per unit.
Price
$
MC
$
S
AC
Market
Supply
Price
Price
D
Qm
Output
(industry
as a whole)
Qf
Output
(Smaller
Scale)
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Monopoly
• A monopolist is a price maker and the firm’s AR curve is the
market and demand curve
MC=S
p
x
Figure 1
z
y
w
AR=D
Qm
Qpc
MR
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• The monopolist has market power and can increase sales
by reducing price.
• As a result AR falls as output increases and MR is always
less than AR
• MR becomes negative when demand becomes inelastic and
further price cuts, though increasing volume, reduce
turnover.
• By restricting output to Qm, the monopolist can charge a
price greater than the average cost; thus making
supernormal profit XYZP
• This represents consumer surplus transferred to the
monopolist. The area WYZ is consumer surplus totally lost
and is called the deadweight loss of monopoly
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• The monopolist restricts output to Qm in order to maximise
profit by producing where MC=MR.
• Qm is not at the lowest point on the AC curve: the
monopolist produces less than under perfect competition
Qpc and at a higher cost. Monopoly does not display
allocative or technical efficiency
Other features of monopoly:
Barriers to Entry:
• Barriers to entry prevent other firms from challenging the
monopolist’s priviliged position
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Barriers:
• Legal (eg nationalisation law & patents)
• Absolute cost (privileged access to cheap raw materials)
• High fixed costs regardless of market share (eg creating
the infrastructure for a phone market)
• Economies of scale where the long run average cost
curve falls indefinitely and new entrants do not have
sufficient market share to operate cheaply
• Product differentiation: an existing product with a
powerful brand can create customer loyalty, thus imposing
very high promotion costs on a new entrant
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Price Discrimination
• Occurs when a firm sells the same product at different
prices in different markets
• The seller must be able to control the supply of the product.
Clearly a monopolist can
• The seller must be able to prevent the resale of the
product. Grouping by status (eg age), time, geography,
permits this. Customer ignorance helps the supplier
• Elasticity of demand must vary between the markets, so
that some customers are wiling to pay a higher price
12
X inefficiency
• Apart from technical and allocative inefficiency, monopolies
may display X inefficiency: they have little incentive to
control costs so their AC curve moves upwards
For Monopolies
• If LRAC falls indefinitely as output increases and economies
of scale continues to rise, the monopolist can charge lower
prices than perfect competition. This is evident in a natural
monopoly
• Monopolies can spend more on R&D
• Find it easier to raise capital for new ventures, which aids
economic growth
• Supernormal profits stimulate competition: a temporary
monopoly under a patent may encourage improvements
13
• Patent rights reward innovation and entrepreneurial flair,
both which are needed for economic growth
Against Monopolies
• The monopolist’s supernormal profit is obtained at the
expense of the consumer
• Monopolies display technical, allocative and X inefficiency
(X-inefficiency is the difference between efficient behaviour of firms
assumed or implied by economic theory and their observed behaviour in
practice)
• Resort to restrictive practices such as price discrimination
to further increase their profits
• Product differentiation wastes resources in the pursuit of
monopoly advantages
• Diseconomies of scale may arise
• If a monopolist controls a vital resource, can take decisions
that affect public interest adversely
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Monopolistic Competition, Oligopoly & Duopoly
Monopolistic Competition
• Monopolistic competition differs from perfect competition in
that firm’s products are comparable rather than
homogeneous.
• Under conditions of monopolistic competition, firms try to
achieve monopoly profits by product differentiation. This
gives each firm power over its own market price. They are
thus price-makers and experience downward sloping
demand (AR) and MR curves, see diagram on next slide.
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Monopolistic Competition
$
MC
AC
p
AR=D
Q
Output
MR
16
Features of Monopolistic Competition
• In the short run the firm can make supernormal profits by
shifting the demand/AR curve to the right. The previous
diagram is then exactly like that of the monopolist in the
long run
• Because there are no real barriers to entry, these profits
can probably be competed away: the demand curve shifts
back left to produce the long run equilibrium shown in the
diagram
• Like monopoly, monopolistic competition does not produce
where AC is at a minimum: it is technically inefficient
• The firm will probably always have excess capacity, for the
same reason
• The extent to which the product differentiation is a real and
thus a source of utility or spuriously created by advertising
will vary from time and product to product
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Contestable Markets
• A contestable market is similar to perfect competition, even
though there are few suppliers.
• A lack of entry and exit barriers deters firms from trying to
obtain supernormal profit.
• The firm produces at minimum AC and where
AC=MC=MR=AR, just as in perfect competition
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Oligopoly
• In an oligopoly a few large suppliers dominate the industry.
These suppliers are independent in their decision making:
they must consider their competitor’s responses to any
changes they make
• The kinked oligopoly demand curve illustrates the
interdependent decision making of competing oligopolies.
While the oligopolist has market power, any change in price
is likely to be met with powerful response.
• The demand is elastic at levels above P since a price rise by
one firm would not be matched and purchasers would deal
with other suppliers.
• The demand curve is inelastic below P: competitors would
match any price cut by one firm and so market share would
not change very much
• The kinked demand curve means an oligopolist has a
discontinuous MR curve. This means there is a trend for
price stickiness in oligopoly, because there is a range of
points where MC=MR
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Oligopoly
$
MC
Kink in the demand
curve
MR
p
X
Y
D
Q
MR
Output
20
• Oligopolists may avoid competing by having an informally
acknowledged price leader who sets the prevailing price or
there may be a formal cartel agreement to control price by
restricting output. This is illegal in the US and EU, though
some countries have official schemes for favoured
industries.
• Because of the uncertainty over pricing decisions in
oligopoly, non-price competition prevails in oligopolybranding and advertising.
Duopoly
• A duopoly is an oligopoly market structure containing only
two firms. The two firms can either collude or compete
• If the firms compete, one firm can only gain at the expense
of the other firm
• This highlights the interdependence between firms
• A firm must decide whether to try increase its market shar
at the risk of retaliation from the other, or allow market
share to remain constant.
• This decision can be seen as game theory
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Market Concentration
• Market concentration is the extent to which supply to a
market is provided by a small number of firms
Market concentration ratio:
• The proportion of output (or employment) accounted for by,
say, the largest three, four or five producers
Herfindahl index
• The market share percentages of all firms in the market are
squared and the squares summed
– Perfect competition index=0
– Pure monopoly index= 10,000
– Used by US to control development of monopoly: indices above 1000
attract review, above 1800 most unlikely to be approved
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Problems with measures of market concentration
• Defining the market: it may appear to be competitive
overall but one firm may monopolise a segment.
• Entry of new firms should reduce concentration but is
unlikely to affect the concentration ratio and may not affect
the Lorenz curve or the Gini co-efficient
23
Public Policy & Competition
Government Control
• Governments intervene in microeconomic matters when
market forces do not produce the outcomes they wish to
see
• The various aspects of market failure invite government
regulation.
• The extreme form of intervention is nationalisation an this
may be undertaken for other reasons
Other justifications for Nationalisations:
• Natural monopolies should not be allowed to exploit their
positions, eg utility companies
• Larger groupings coul exploit further economies of scale to
natural advantage (aerospace)
• Only government can supply enough finance for some
industries (railway networks)
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• Political control over strategic industries (oil production)
• Marxist/socialist theory: the political left is more or less
uncomfortable with capitalism and wishes to control
industry for the benefit of its client groups (eg coal mining)
Government response to market failure
• Monopoly elements: controls on prices or profits- breaking
up monopoly companies
• Externalities: regulations (eg to control pollution, compel
car insurance, ban smoking)
• Imperfect information: product safety rules, public service
advertising, provision of jobcentres
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• There has been a move away from government control of
industry in many countries over the last 20 years
Reasons for reducing the degree of government control
• Nationalised industries being run for the convenience of
their staffs rather than their customers
• Civil servants and politicians not good at commercial
decision making
• Sale of state assets permits tax cuts and reduces need for
government borrowing
• Enhanced competition seen as likely to improve efficiency
and promote growth
• Reduction in enforcement costs and unintended
consequences of regulation
• Wider share ownership
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Privatisation
• It is possible to discern several strands in privatisation
– 1) Deregulation, to allow private firms to compete with state-owned
ones, (postal service)
– Contracting out of government work previously done by government
employees (waste collection)
– Outright sale of business to private shareholders (BT)
Privatisation has been criticised:
– Creation of private monopolies
– Sale of assets at a discount
– Enhanced top executive benefits
– Decline in the quantity and quality of service
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Promoting Competition
• Western governments promote competition in most areas
of economic activity since it is simple and cheap way to
achieve economic efficiency and growth
• Competition Act 1998: anti-competitive arrangements are
necessarily against the public interest and so should be
illegal
• Enterprise Act 2002: This act makes operating a cartel a
criminal offence in the UK
• The Uk Competition Commission: investigates mergers and
market share over 25%
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Finance & Financial Intermediaries
Functions & Qualities of Money
• 4 Main functions:
–
–
–
–
Medium of exchange
Act as a store of value (impaired by inflation)
Unit of account
Standard of deferred payment
Qualities of money:
–
–
–
–
–
Durability
Acceptability of both buyers and sellers in a transaction
Transportability
Maintains a stable value and purchasing power (reduced by inflation)
Not easily counterfeited
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The flow of funds
Households
Firms
•
•
•
•
Government
Funds flow between the three main parts of the economy
Households, firms and governments borrow in order to
obtain funds in addition to income
Funds may be used for capital investments or to cover a
gap in the flow of income
Households and firms may have a surplus of income that
they are prepared to lend in order to earn interest
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• Governments also lend, but mostly in order to finance
activity they wish to promote, rather than to earn interest
Solvency requires a balance between income and expenditure
but payments and receipts cannot always by synchronised
since there may be irregularity of income and expenditure
will cover both small and large items (see table 1 below)
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Table 1
Reason for Irregularity of income
Reasons for peaks of
expenditure
Households
Variations in fees & overtime: causal
Household purchase;
labour; periodic receipt of investment holidays; property
income
maintenance; major
purchases
Firms
Seasonal and cyclical variations in
trade receipts; periodic receipt of
investment income
Capital expenditure; tax
payments; finance of
working capital
Governments
Seasonal and cyclical variation in tax
receipts
Seasonal & cyclical
variation in welfare &
other payments; natural
disasters and other
contigencies
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Financial Intermediation
• Financial intermediaries provide the facilities and financial
instruments to transfer funds from surplus units, or lenders,
to deficit units or borrowers in the business, personal,
overseas & government sectors
• Clearing or retail banks provide banking services to the
public
• Investment banks or “merchant banks” provide advice and
major finance to corporate clients
• Insurance companies, pension funds, unit trusts &
investment trusts make longer term investments for clients
Functions of Financial Intermediaries
• Aggregation: relatively small deposits can be combined into
major loans for borrowers
• Maturity transformation: by receiving a constant flow of
savers and lending to a large number of borrowers,
intermediaries can spread risk of any non-payment of debt,
whereas that risk may have been too high for an individual
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lender to lend to a single borrower
• Source of funds: borrowers are assisted to obtain the funds
they need
Financial Instruments
Borrowing
Lending
Short Term
Short Term
Overdraft
Deposit a/c
Bills of exchange payable
Money market
Bills of exchange receivable
Medium Term
Medium Term
Bank loans
Term deposits
Hire purchase
Certificates of deposit
Finance leases
Bank loans
Long Term
Long Term
Debentures
Bank loans
Mortgages
Mortgages
Equity (way of raising capital)
Equity
Bank loans
Debentures
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Institutions & Markets
Capital Markets:
• London stock exchange
– 1) Main market; with firm regulation, for raising funds through new
issues of shares and trading existing shared
– Alternative Investment Market: for newer companies, less firmly
regulated
• Gilt edged market for UK government stock
• International capital markets are operated between
banks in larger countries to provide major finance for very
large companies and institutions. Confusingly, their
securities are known as Eurobonds
• Certain stocks not traded on recognised stock exchanges
are traded in over the counter markets
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Money Markets:
• Short term investment and borrowing of funds is handled
on the money markets. These are operated by the banks
and other financial institutions and include markets for:
–
–
–
–
–
Certificates of deposit
Bills of exchange and commercial paper
Treasury bills
Building society bulk borrowing
Local authority bills and other short term borrowing
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Insurance
• Insurance transfers risk from one party to another, in return
for a payment, called a premium. Insurance companies are
intermediaries in the risk market
• An underwriter is a person who estimates and accepts risk,
normally on behalf of an insurance company or other risk
bearer
• Assurance deals with risk of something definitely happening
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Credit & Banking
Banks & Credit
Functions of Commercial Banks:
• Payments mechanism: payments made by cheque cleared
and net balances transferred via banks’ deposits at the
central bank
• Storage & safeguarding of wealth: most accounts attract
interest
• Lending money: earn income by charging interest
• Financial Intermediation
• Business Services: foreign exchange dealing; bill
discounting; business advice; insurance broking...etc
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Banks & Assets & Liabilities:
• Banks aim to use money in their possession to make
profits. At the same time they have to ensure the security
of their assets and maintain sufficient liquidity to meet their
customers’ requirements for cash. They therefore maintain
an asset structure of graduated liquidity & profitability
• Cash:
–
–
–
–
Market loans
Bills (usually repayable in 90 days)
Advances (term loans)
Investments
More Liquid
Less Liquid
• Central banks use the Basle Agreement rules on capital
adequacy to supervise their banks and ensure they have
sufficient provision for bad debts
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The Credit Multiplier
• The bank or credit multiplier is the name given to banks’
ability to create credit and hence money, by maintaining
their cash reserves at less than 100% of the value of the
deposits they hold
The basics of credit creation:
– The total amount of money in a modern economy is many times the
amount of cash in circulation
– A bank receiving a deposit is able to lend most of it out, retaining only
a small proportion to meet the depositor’s needs
– The money lent is in turn deposited and supports a further loan
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Calculating the credit multiplier
• The relationship between the amount of a deposit and the
credit that can be based on it is called the credit multiplier
and takes the form:
Deposits= Cash/Cash Ratio or D=C/R
• Where the cash ratio is the % of the cash deposited the
bank feels is prudent not to lend.
• Thus with a cash ratio of 20%, a cash receipt of 1,000euro
can support total deposits of 5,000euro
• The 1,000euro originally paid in and 4,000euro credited to
borrowers’ accounts.
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Yield
• There are two aspects of yield on an investment:
– Interest (on dividends)
– Capital Growth
• Interest is paid separately from repayment of the principal.
Capital growth can only be realised when the investment is
repaid or sold
• Bonds normally pay a fixed rate of interest: this is the
nominal or coupon rate. Running or current yield on a bond
is found by dividing its market price into its nominal rate
• Net dividend yield on equities is similar: current share
price is divided into the annual net dividend income
• Bills of exchange and other bills such as treasury bills
provide yield by being offered at a price lower than their
maturity or face value: the bill rate is thus a measure of
capital growth
• Yield Maturity includes both interest and capital
appreciation
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43
The Term Structure of Interest Rates
R%
This normal yield curve illustrates
the way interest rates vary with the
term of the loan.
There is greater risk of losses from
default and inflation the longer the
term of the loan .
Longer term loans therefore attract
higher interest rates
Term
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• The normal yield curve rises in the longer term
–
–
Increased uncertainty about the more distant future increases the risk premium
Investors wish to avoid being locked into low yields in case interest rates generally rise
• Reverse yield curves indicate market expectation of future
interest rate reductions
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The Central Bank
• A country’s central bank plays a vital role in the
management of the monetary system.
• The functions of any given central bank may vary from
those of another, especially in the areas of monetary policy
and financial supervision.
Functions of The Central Bank:
• Provides a banking service to the government
• Central note issuing authority
• Manages the National Debt
• Lender of last resort
• Banker to the commercial banks, holding operational
deposits to permit interbank transfers: can require special
deposits to control money supply
• Manages national foreign currency reserves
• Monetary Policy Committee sets the UK benchmark interest
rate
46
Setting the Interest Rates
• The bank’s interest rate policy must also take account of
the need to expand the money supply to support economic
growth
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Key points from Section B to know for the assessment
(i) identify the equilibrium price in a product or factor markets
likely to result from specified changes in conditions of
demand or supply;
(ii) calculate the price elasticity of demand and the price
elasticity of supply;
(iii) identify the effects of price elasticity of demand on a
firm’s revenues following a change in prices;
(iv) explain market concentration and the factors giving rise to
differing levels of concentration between markets;
(v) explain market failures, their effects on prices, efficiency
of market operation and economic welfare, and the likely
responses of government to these;
(vi) distinguish the nature of competition in different market
structures;
(vii) identify the impacts of the different forms of competition
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on prices and profitability.
Key points from Section C to know for the assessment
(i) identify the factors leading to liquidity surpluses and
deficits in the short, medium and long run in households,
firms and governments;
(ii) explain the role of various financial assets, markets and
institutions in assisting organisations to manage their
liquidity position and to provide an economic return to
holders of liquidity;
(iii) explain the role of insurance markets in the facilitation of
the economic transfer and bearing of risk for households,
firms and governments;
(iv) explain the role of the foreign exchange market and the
factors influencing it, in setting exchange rates and in
helping organisations finance international trade and
investment;
(v) explain the role of national and international governmental
organisations in regulating and influencing the financial
system, and the likely impact of their policy instruments on
businesses.
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