LEARNING OUTCOMES 3 & 4
PRODUCER BEHAVIOUR
IN THE OPERATION
OF THE MARKET
PRODUCER BEHAVIOUR
Producers pay for factors of production which they combine
to produce goods and services.
Short Term
Rent Wages Interest Profit
Factor Costs
Land Labour Capital Enterprise
Factor Inputs
only one factor variable
(usually labour)
 Output
Long Term
all factors
variable but
technology
fixed
Very Long Term
In order to attract the right factors of production
all factors and the
away from their present use, entrepreneurs may have state of technology
to pay Economic Rent- the cost over and above what
is variable
they are presently earning.
Transfer Earnings is what factors earn in their next best use.
OUTPUT IN THE SHORT TERM
When only one factor (usually labour) is variable and the others fixed,
total output will at first rise at an increasing rate, then rise at a
decreasing rate, then will eventually fall.
This is due to the law of variable (diminishing) returns to labour
which says that as more and more labour is added to fixed
factors, marginal output – that which is contributed by the last man
added - will initially rise, then fall, then become negative.
Output
Total
Output
Marginal
Output
Units of Labour
AVERAGE AND MARGINAL OUTPUT
Output is often referred to as product (as in production).
When we plot average output per man and marginal output per
man on the same graph we can see an important relationship.
Output
Marginal
Product
Average
Product
Units of Labour
While Marginal Product is higher than Average Product, technical
efficiency is increasing and Average Output is rising.
When Marginal Product is lower than Average Product, technical
efficiency is decreasing and Average Product is falling.
AVERAGE PRODUCT AND AVERAGE COST
Due to the fact that Average Product per unit of labour
increases and then decreases because of the law of variable
returns, then Average Costs are “U-shaped”.
Cost
£
Average
Cost
Output
Average Costs at first fall, reach a minimum, then start to rise
again.
The lowest point on the Average Cost Curve is known as the
optimum output.
TOTAL AND AVERAGE COSTS
Total Costs
Total Costs
Costs
Variable Costs
Fixed Costs
output
Average Costs
These are each
of the above
costs divided
by output at
each level of
output.
Costs
Average
Total
Cost
Average
Fixed
Cost
Output
Average
Variable
Costs
AVERAGE AND MARGINAL COSTS
When we plot the Average Cost and Marginal Cost Curves on
the same graph we see an important relationship between them.
Costs
Marginal
Cost
Average
Cost
Output
While Marginal Cost is lower than Average Cost, Average Cost
is falling and economies of scale are being achieved.
When Marginal Cost is higher than Average Cost, Average Cost
is rising and diseconomies of scale are being experienced.
The Marginal Cost Curve always cuts through the Average Cost Curve
from below at the lowest point (optimum output) on the Average Cost
Curve.
PROFIT IN THE LONG TERM
In economics it is assumed that entrepreneurs’ prime motivation
is profit.
Entrepreneurs will combine resources in order to produce goods and
services for which consumers express effective demand.
Through the sale of these goods and services at a price higher than
the cost of production, entrepreneurs earn their return – profit.
Profit will be maximised by entrepreneurs when the marginal revenue
charged for the last item sold (ie its price) equals the marginal cost
of producing it.
To reach the level of output at which this occurs, entrepreneurs will
strive to take advantage of economies of scale through specialisation,
the division of labour and to achieve technical efficiency through the
use of the least resources necessary and economic efficiency by using
resources in their highest valued uses.
ECONOMIES OF SCALE
These fall into 2 categories – Internal and External Economies
of Scale.
INTERNAL ECONOMIES
EXTERNAL ECONOMIES
• Technical
• Good Infrastructure
• Pool of skilled labour
• Marketing
• Ancillary Firms
• Financial
• Co-operation
• Risk Bearing
• Managerial
• Administrative
It is to achieve these economies that most firms strive to grow.
This can be done through : internal growth
amalgamation
integration – takeover
merger
INTEGRATION
Integrating with other firms will enable firms to grow.
Integration can be:
horizontal
vertical
lateral
Horizontal Integration
Where firms in the same industry and at the same stage of
production integrate.
Vertical Integration
Where firms in the same industry but at different stages in
the production process integrate.
Lateral Integration
Where firms at the same stage of production but in different
industries integrate.
QUIZ
Name the 4 factor inputs.
Name the 4 factor costs.
Land, Labour, Capital, Enterprise
Rent, Wages, Interest, Profit
What is meant by ‘the short term’?
Period in which only one factor can vary.
What is meant by ‘the long term’?
Period in which all factors vary except
the state of technology.
What is meant by ‘the very long term’? All factors and technology can vary.
When is economic rent paid?
To attract factors away from their
present use.
What is meant by transfer earnings?
Payment to a factor in its next best use.
Why do returns to labour diminish?
Too much labour to capital.
What is meant by optimum output?
Level of output with the lowest AC.
What are economies of scale?
Savings made by scaling up output.
At what point are profits maximised?
The output at which MC = MR.
Give an example of vertical integration. Farm, flour mill, bakery, baker’s shop.
MARKET STRUCTURE
A market is any situation which allows buyers and sellers to interact.
Markets differ mainly in the following 5 areas:
•
•
•
•
•
the number of firms operating
the size of the firms operating
the number of customers
the type of competition used eg price, marketing
ease of entry into and exit from the market
The most competitive markets are those in which there are lots of
suppliers supplying the same product to lots of consumers.
In a perfectly competitive market there are so many buyers and sellers that
no-one is able to influence market price through their own individual actions.
Suppliers are therefore price takers since they are unable to influence price.
If a supplier tries to raise price customers will simply find an alternative firm.
Suppliers can maximise abnormal profits in the short run by supplying up to
the point where MC = MR.
In the long run new firms will be attracted in, increasing supply to such an extent
than price is forced down for all firms and only the lower cost firms are able to
continue to make abnormal profits.
PERFECT COMPETITION
The individual firm in Perfect Competition faces a horizontal demand curve due
the suppliers all being small in size and large in number, all supplying the same
product.
This is what makes the firm
Marginal
in this market a ‘price taker’.
Price
Cost
Average
Cost
AR = MR = PRICE
Quantity Demanded
As new firms enter the market,
attracted by the abnormal profits
available, price is forced down due
to the extra supply.
Firms which can keep their costs
low will make most profits.
Firms which are unable to keep costs low will leave the market when they
cease even to make normal (built-in) profits.
Examples of perfectly or nearly perfectly competitive markets are coffee,
cotton, and wheat where price is established in the world market and individual
farmers have to accept this price.
IMPERFECT COMPETITION
Imperfect markets are any markets which are not perfect and describe:
• monopoly
• oligopoly
• monopolistic competition
• monopsony
MONOPOLY
This describes a market with only one supplier and many buyers.
It’s monopoly position is determined by the strength of the barriers to entry
to new firms which it erects and the availability or otherwise of substitutes.
The monopolist can determine either the price at which to sell or the quantity
it wants to sell but not both.
The government will monitor, and where necessary, regulate the actions of
monopolies (in reality, firms which supply more than 25% of the total ) through:
• regulators/watchdogs such as Oftel, Ofwat,
• The Competition Commission, previously the Monopolies & Mergers Commission.
OLIGOPOLY
This is a market dominated by a handful of large firms.
Unlike perfect competition and monolopy, this is a fairly common market type.
Examples of this market type are petrol and detergents.
The detergent market is a special type of oligopoly known an duopoly because
it is dominated by 2 large firms (Proctor & Gamble and Unilever who each
control over 40% of the market for these products, the remaining 20% is
shared by all the other detergent manufacturers).
Price competition is not possible in this market structure due to the kinked
demand curve ie it has an elastic top section
Marginal
Price
Cost
and an inelastic bottom section.
Average
Knowledge by firms of the actions of
Cost
the other firms in this market is such that
each knows what the others are doing.
This means that if one firm raises price
the others do not and therefore they
Quantity
attract customers away from that firm.
Competition tends to be through
If one firm reduces price, the others do product differentiation and advertising
follow suit and therefore no-one gains
and firms may collude to erect barriers
over the others.
to entry.
OTHER MARKET STRUCTURES
MONOPOLISTIC COMPETITION
A market with a large number of firms each producing a differentiated or
branded product to a large number of buyers. Firms have some control over
price and market share due to customer loyalty to the brand or firm’s name.
Other firms can enter the market due to the weak
barriers to entry.
Restaurants and hairdressers are examples of this
market structure.
MONOPSONY
This is a market with only one buyer and many suppliers.
In this market structure it is the buyer who has the control to negotiate
price, product specification and delivery.
An example might be the MacDonalds chain
which is so large that it can dictate to
suppliers exactly what it wants or it could
take its custom elsewhere.
PRICING POLICIES
Ultimately prices are determined by market forces ie the interaction of demand
and supply, so that if firms price their products higher than customers are willing
to pay, price is forced down.
Firms price their products in a number of different ways:
Competition based pricing – due to the large number of suppliers each firm is
forced to take the market price and produce
accordingly in order to maximise profit.
Penetration pricing – new entrants to the market may undercut existing firms in
order to establish a customer base.
Predatory pricing – existing firms lower price to force out new entrants who have
not yet built up reserves or economies of scale to compete.
Highest price possible – monopolists may charge the maximum price they think
the customers will bear.
Price discrimination – when a firm sells to different customers at different prices
thereby maximising revenue eg air fares and telephone calls.
Psychological pricing – higher prices brand to create the impression of better
quality eg Haagen Dazs ice cream.
QUIZ
What is a market?
What are the main defining
characteristics of a market?
Any situation where buyers and sellers can
interact
Size, number of firms, number of
customers, ease of entry, type of
competition.
Describe the demand curve faced
by a firm in perfect competition.
Horizontal
Describe the demand curve faced
by a market in perfect competition.
Downward sloping from left to right.
Does the firm in perfect competition Yes, in the short run.
make abnormal profits?
Name 2 barriers to entry erected by Patents, expensive advertising to create
a monopolist.
Powerful brand image
Why is an oligopolist’s demand curve Elastic section above the kink and inelastic
below due to the perfect knowledge of the
‘kinked’?
market leaders.