Theme 3: Business behaviour and the labour
market
Overview
This theme builds on the content of Theme 1: Introduction
to markets and market failure and focuses on business
economics.
Students will need to build upon the knowledge, skills and
understanding developed from Theme 1 in Theme 3,
making connections across these two microeconomic
themes in Paper 1, and across Themes 1, 2, 3 and 4 in
Paper 3. Teaching approaches to content must reflect this.
Students will need to apply their knowledge and
understanding to both familiar and unfamiliar contexts in
the assessments and demonstrate an awareness of current
economic events and policies.
Content
This theme examines how the number and size of market
participants, and the level of contestability, affect the
pricing and nature of competition among firms. Students
will consider the size and growth of firms through exploring
organic growth, mergers and takeovers. They will look at
the reasons for demergers and why some firms tend to
remain small.
Students will look at the rational assumption that firms are
profit maximisers and then challenge this by looking at
alternative business objectives. Revenues, costs and profits
are explored before linking these ideas to different market
structures. Students will then be able to analyse and
evaluate the pricing and output decisions of firms in
different contexts and understand the role of competition in
business decision making. Supply and demand analysis is
specifically applied to the labour market to see how wages
are determined in competitive and non-competitive
markets.
At the end of this theme students should be capable of
making an appraisal of government intervention aimed at
promoting competitive markets.
This theme will provide a coherent coverage of
microeconomic content, drawing on local, national and
global contexts.
Students are encouraged to use an enquiring, critical and
thoughtful approach to the study of economics and to
develop an ability to think as an economist.
To develop their skills, knowledge and understanding in
economics, students need to have acquired competence in
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quantitative skills that are relevant to and applied in the
context of this theme (see Appendix 3: Quantitative skills).
3.1 Business growth
Subject content
What students need to learn:
3.1.1
a) Reasons why some firms tend to remain small and why
others grow
Sizes and types of
firms
-
Monopolists of small firm
Barriers of entry may be low so some firms may
enter and choose to not expand to provide to a local
area where as others may choose to expand (more
customer base)
b) Significance of the divorce of ownership from control:
the principal-agent problem
-
Larger firms have a divorce of ownership from
control
Smaller firms involve the owner directly running the
business
Principal agent problem occurs when the agent is
making decisions on the behalf of another group
Agents may give more importance to themselves as
opposed to shareholders.
c) Distinction between public and private sector
organisations
-
Ministry of defense, City councils, NHS.
Purpose of public sector is to provide a service to the
citizens, making a profit is not an aim.
Private sectors:
Main aim to make a profit
Divorce of ownership from control means that
making a profit is important.
d) Distinction between profit and not-for-profit
organisations
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How businesses grow:
organic growth
 Refers to firms increasing their output
 forward and backward – Forward means
supplier merging with buyers, backwards
means purchaser buying a supplier
 vertical integration
 Refers to the merger between firms at
different production stages.
o horizontal integration
 Refers to the merger between two firms in the
same industry at the same stage of
production
o conglomerate integration
 Merging of two firms with no common interest
Advantages and disadvantages of:
organic growth
 Merging with another firm is expensive and
time consuming, expansion is far easier as
buying additional capital goods or hiring
workers is far easier than the earlier.
o vertical integration
 Integrating a buyer and supplier into a firm
may be more efficient and cost beneficial
 Control better branding
 Protect against patent holding risks
 Wide array of expertise
 The firm’s price may fall (the one that’s being
bought)
 Many of the key workers may leave
 Difficulty in merging firms, due to extra layers
of management etc.
o horizontal integration
 May allow for reduction in AC
 Can reduce competition
 May allow one firm to buy unique assets
 Grow in a matured market
o conglomerate integration
 No expertise in what in the particular market.
Constraints on business growth:
 size of the market
 Markets vary in size, sometimes expanding
the business may fail due to the lack of
customers.
o access to finance
 To expand firms, need money, this may be
done in selling shares to investors, equity
funding, and using loans and overdrafts or
simply reinvesting profit
o owner objectives
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
Owners may be satisfied with current profit
levels or simply do not want to deal with the
stress of expansion
o regulation
3.1.3
Demergers
a) Reasons for demergers
-
-
-
Lack of synergies: management may feel that
there is no synergy in the part of a firm, there by
they could feel like time is being wasted due to the
time having spent on both firms that are unrelated to
each other.
Price: The valuation of two demerged firms may be
greater than the value of a single firm, there by
combining the poor performance of one firm and the
good performance of another may overall hinder the
valuation.
Focused companies: Its simply better to be
number one than three or four, as management has
limited resources themselves, its better to sell off
and focus on one specialty rather than try to
diversify.
b) Impact of demergers on businesses, workers and
consumers
- Businesses: Firms will benefit from a demerger if
the specialization leads to greater efficiency. Firms
will loose out of the demerger leads to lesser
efficiency.
- Workers: Senior managers may gain promotion, as
each company will need a senior manager, on the
other hand, some workers may loose their job as a
result of increased efficiency.
- Consumers – Same points as above, efficiency =
cost less, inefficiency = cost more or potential of firm
failure.
3.2 Business objectives
Subject content
24
What students need to learn:
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3.2.1
Business objectives
a) Different business objectives and reasons for them:
-
profit maximisation
-
revenue
maximisation
-
sales maximisation
-
satisficing
b) Diagrams and formulae to illustrate the different
business objectives: o profit maximisation o revenue
maximisation o sales maximisation
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3.3 Revenues, costs and profits
Subject content
What students need to learn:
3.3.1
a) Formulae to calculate and understand the relationship
between:
Revenue
total revenue
 the total amount of money received
from the sale at any given level of
output
 TR=QP
average revenue


average per unit sold
AR = TR/Q
marginal revenue
 MR = d(TR)/d(Q)
 Receipts from selling an extra unit of
good
b) Price elasticity of demand and its relationship to revenue
concepts (calculation required)
- If the price received by a firm for a good is constant,
that means the elasticity for demand is perfectly
elastic, whatever percentage change in price of good,
no change in demand
- When price of good declines as sales increase, there
will be a price elasticity change as well, if the
percentage fall in demand is less than the pricentage
rise in price, the total revenue increases. If demand
is price elastic, than percentage rise in price will
bring a larger percentage fall in qty demanded.
- In marginal revenue, the demand is price elastic as
long as MR is positive.
- When MR is negative, demand is price inelastic
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3.3.2
Costs
a) Formulae to calculate and understand the relationship
between:
total cost
TVC + TFC = TC
refers to all the costs associated with
running a business, including any potential
economic costs associated with any
activities within a business, this includes
social and expense.
total fixed cost
a fixed cost does not directly vary with
output, it is also known as the overhead
costs.
total variable cost
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the variable costs refer to the costs that
are associated as increasing with means of
production and productive output, such as
raw material.
Important to note that labor is a semi
variable cost, for example they might
be permanent staff or temporary.
average (total) cost
AC = TC / Q
In the long run, all costs are variable costs
since all factors of production can be
changed
average fixed cost
TFC / Q = AFC
average variable cost
TVC / Q = AVC
marginal cost
MC = D(TC)/D(qty)
the cost of producing an extra unit of good
b) Derivation of short-run cost curves from the assumption
of diminishing marginal productivity
-
-
Diminishing marginal productivity refers to the
productivity limit that the fixed capital can support
with varied capital. i.e., factories and workers.
Law of diminishing returns states that if
increasing quantities of a variable input and
combined with fixed input, eventually the marginal
product and the average product of that variable
input will decline
c) Relationship between short-run and long-run average
cost curves
- Returns to scale: means that an equal percentage
increase in inputs to production leads to a more than
proportion increase in output.
- Constant returns to scale if an equal percentage
increase in input leads to same percentage increase
in output
- Decreasing returns to scale means equal
percentage in input returns a less than proportaion
increase in output
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a) Types of economies and diseconomies of scale
-
-
3.3.3
Economies and
diseconomies of
scale
-
Technical economies – increasing and decreasing
returns to scales, where unit costs change as far as
the firm size changes, thereby leading to economies
of scale or diseconomies of scale
Managerial economies – specialization in a firm
may lead to greater efficiency and therefore lower
costs
Purchasing and marketing economies – the larger the
bulk bought the larger the lower price discount.
Financial economies – small firms find it difficult
and expensive to raise finance for new investment
Diseconomies of scale arise mainly due to
management problems, geography may also
lead to higher AC.
b) Minimum efficient scale
c) Distinction between internal and external economies of
scale
- External economies of scale refer to the growth in the
size of the industry in which the firm operates in,
where as internal is the growth in the output of the
firm, or perhaps growth in the particular industry or
area.
- External diseconomies of scale will shift the long run
AC of individual firms upwards/to the right
a) Condition for profit maximisation
3.3.4
Normal profits,
supernormal profits
and losses
-
Profit is maximized at a level when the gap between
total revenue and total cost is the greatest.
MC = MR
b) Normal profit, supernormal profit and losses
-
Normal profit = AC = AR
Supernormal profit means any profit that is greater
than the normal profit
c) Short-run and long-run shut-down points: diagrammatic
analysis PG 255 REVISION
3.4 Market structures
Subject content
What students need to learn:
3.4.1
a) Allocative efficiency
Efficiency
-
Occurs when resources are distributed to the goods
and services consumers want, it maximizes utility
P = MC
S=D
Any point in PPF
b) Productive efficiency
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When firms produce at the lowest point on the AC
curve, since the mc curve cuts the AC curve at the
lowest point, MC = AC is productive efficiency.
c) Dynamic efficiency
-
When resources are allocated efficiently over time,
which leads to falling LRAC.
Affected by short run factors such as demand,
interest rates and past profitability.
Short run costs may be increase for long run costs to
fall
d) X-inefficiency
-
X efficiency occurs when it is producing on the AC
boundary.
Could be due to organizational slack, waste of
production process, poor management or just
laziness. Monopolies are typically x inefficiency.
e) Efficiency/inefficiency in different market structures
3.4.2
Perfect competition
a) Characteristics of perfect competition
-
Large number of firms, none of which is large
enough to dominate the market
Abundance of purchasers to support these small
suppliers
Freedom to entry and exit from the industry.
Perfect knowledge of prices, both buyers and sellers
possess.
All firms produce a homogenous product, no
branding of product and products are identical.
Demand curve is flat.
b) Profit maximising equilibrium in the short run and long
run
-
Short run profit maximizing means MC = MR, as AR
is greater than AC, it makes an abnormal profit
c) Diagrammatic analysis
- Just attach the graphs
3.4.3
Monopolistic
competition
a) Characteristics of monopolistically competitive markets
-
Almost the same assumptions as perfect competition
Large number of buyers and sellers on the market,
each of which is small
No barriers to entry or exit
Firms are short run profit maximizers
Firms produce non homogenous goods.
b) Profit maximizing equilibrium in the short run and long
run
-
-
Firms will produce at MC=MR at the short run.
Where as in the long run, firms will continue to
produce at MC=MR, it will charge a price based on
its demand or AvgRevCurv
AC = AR because competitive pressures mean a firm
cannot make a loss or earn an abnormal profit
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c) Diagrammatic analysis
d) REFER TO BOOK
3.4.4
a) Characteristics of oligopoly
Oligopoly
o
high barriers to entry and exit
o
high concentration ratio
-
Supply in the industry must be concentrated in the
hands of a few firms. Along side a few large
producers there’s many smaller ones.
o
-
interdependence of firms
The actions of one firm will directly affect
another. In perfect competition firms are
independent, however in oligopoly it is different
where if one firm seeks to increase sales, it will
affect the other ones.
o
-
product differentiation
It depends on the market.
b) Calculation of n-firm concentration ratios and their
significance
c) Reasons for collusive and non-collusive behaviour
-
To raise average revenue for higher profits
d) Overt and tacit collusion; cartels and price leadership
-
-
An agreement has to be reached
No cheating
Potential competition must be restricted.
Overt collusion is open for everyone to see, such as
the OPEC.
Tacit collusion is unwritten and based more upon
analyzing behavior and unspoken rules being
developed out of it.
One form of tacit collusion is price leadership.
e) Simple game theory: the prisoner's dilemma in a simple
two firm/two outcome model
f)
explained
Types of price competition:
price wars
occur where non price competition is weak,
consumers may be failed to be convinced
that the higher prices are better than the
competitor’s product, or when collusion
fails formally or tacitly.
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Price wars tend to drive prices down to the
point where prices are low enough for the
firm to be making a loss.
Predatory pricing
occurs when established firm is threatened
by a new entrant, the established firm
responds by setting a low price so the new
entrant cannot make a profit.
Aim is to drive the new entrant out of the
market.
Then regular price is restored.
limit pricing
limit pricing occurs when firms set a low
enough price to deter new entrants from
coming into a market.
g) Types of non-price competition
- Product, price, promotion, brands.
- Delivery dates, different ways of being more
attractive basically.
3.4.5
a) Characteristics of monopoly
Monopoly
-
Only one firm in the industry
Barriers to prevent new firms from entering the
market
Short run profit maximizer.
b) Profit maximizing equilibrium
-
MC=MR
c) Diagrammatic analysis
d) Third degree price discrimination:
o
necessary conditions
o
diagrammatic analysis
costs and benefits to consumers and
producers
o
e) Costs and benefits of monopoly to firms, consumers,
employees and suppliers
-
f)
Subject content
Some consumers may benefit from price
discrimination
Natural monopoly
What students need to learn:
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3.4.6
Monopsony
a) Characteristics and conditions for a monopsony to
operate
-
A monopsony exists when t here is only one buyer in
the market.
It needs to possess the same characteristics of a
monopoly except for buyers and sellers.
So sellers cannot sell to other firms outside the
market.
Equilibrium price
b) Costs and benefits of a monopsony to firms, consumers,
employees and suppliers
- The monopsonist gains by being able to buy at lower
prices, leads to lesser cost of production and an
increase in overall output.
- Supplers are likely to lose out from a monopsony,
prices paid for their services will fall.
- Customers may benefit from the lower costs on the
monopsonists, however the extent to which this
happens depends on the price elasticity, if supply is
highly price inelastic, there’ll be little fall in supply.
3.4.7
Contestability
a) Characteristics of contestable markets
-
The number of markets may vary from one to
many.
Freedom to entry and exit
Firms compete and do not collude
Short term profit maximizers.
Perfect knowledge and homogenous goods.
b) Implications of contestable markets for the behaviour of
firms
-
-
In the short-term existing firms may be earning an
abnormal profit. However, market theory suggests
that established firms in a contestable market only
earn normal profit even in the short run.
Hit and run competition would only be countered
for the existing firm to set a price level where it is
earning a normal profit.
c) Types of barriers to entry and exit
-
-
34
Capital costs: buying a corner shop is much
cheaper than buying a factory.
Sunk costs: costs such as advertisement cannot be
recouped and thereby are considered to be a sunk
cost if the business fails, thereby discouraging as the
high sunk costs mean the cost of failure for firms
entering the industry will be high.
Scale economies: experienced firms will have lower
AC costs and thereby can satisfy the needs of
buyers, however any new firm that tries to enter will
be discouraged as they may not be able to match the
price output of said firms. Could lead to a natural
monopoly where only one firm survives.
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-
-
-
-
-
Natural Cost advantages: Some producers own
factors that are superior to others, for example a
petrol site next to a busy road vs far away in the
country side.
Legal Barriers: certain firms may have particular
privileges, patent law can prevent competition for a
number of years by not allowing competitor firms to
produce the product, or similarly, they might make
nationalized industries into monopolies by not
allowing private firms to setup in the industry.
Marketing Barrier: Certain firms may erect very
high barriers through smart marketing or investing a
lot of resources into it, where as a new firm will need
to spend a lot in order to be noticed and for
consumers to overcome the powerful brand image of
the more experienced competitor firm
Limit Pricing: firms may choose to set lower prices
than they would charge if they maximized short run
profit, this is done to keep out new entrants
Anti-Competitive Practices: Firms deliberately
restrict competition through restrictive practices, for
instance, a manufacturer may refuse to sell goods
which stocks the product of a competitor firm
Barriers to exit:
Barriers to exit are low, barriers to exit are barriers
which prevent a firm from leaving the industry
quickly and at little cost. A firm may be locked into a
contract where if it breaks the contract, it will have
to pay a large penalty, or leases.
d) Sunk costs and the degree of contestability
- No market is perfectly contestability, there’s always
barriers to entry and exit, some markets are highly
contestable and some aren’t
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3.5 Labour market
Subject content
What students need to learn:
3.5.1
a) Factors that influence the demand for labour
Demand for labour
b) Demand for labour as a derived demand
3.5.2
a) Factors that influence the supply of labour to a particular
occupation
Supply of labour
b) Market failure in labour markets: the geographical and
occupational mobility and immobility of labour
3.5.3
a) Diagrammatic analysis of labour market equilibrium
Wage determination
in competitive and
non-competitive
markets
b) Understanding of current labour market issues
c) Government intervention in the labour market:
o
maximum and minimum wages o public
sector wage setting o policies to tackle labour
market immobility
d) The significance of the elasticity of demand for labour
and the elasticity of supply of labour
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3.6 Government intervention
Subject content
What students need to learn:
3.6.1
a) Government intervention to control mergers
Government
intervention
b) Government intervention to control monopolies:
o
price regulation o profit regulation o quality
standards o performance targets
c) Government intervention to promote competition and
contestability:
enhancing competition between firms
through promotion of small business
o
o
deregulation o competitive tendering for
government contracts o privatisation
d) Government intervention to protect suppliers and
employees:
restrictions on monopsony power of firms o
nationalisation
o
3.6.2
The impact of
government
intervention
a) The impact of government intervention on:
o
prices o profit o
efficiency o quality o
choice
b) Limits to government intervention:
regulatory
capture o
asymmetric
information
o
Theme 4: A global perspective
Overview
This theme builds on the knowledge and skills gained in
Theme 2: The UK economy – performance and policies, and
applies them in a global context.
Students will need to build upon the knowledge, skills and
understanding developed from Theme 2 in Theme 4,
making connections across these two macroeconomic
themes in Paper 2, and across Themes 1, 2, 3 and 4 in
Paper 3. Teaching approaches to content must reflect this.
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Students will need to apply their knowledge and
understanding to both familiar and unfamiliar contexts in
the assessments and demonstrate an awareness of current
economic events and policies.
Content
Students will be expected to understand the significance of
globalisation, international trade, the balance of payments
and exchange rates. They will examine public finance,
macroeconomic policies and the role of the financial sector
in a global context. Students will consider the factors
influencing the growth and development of emerging and
developing countries.
In examining these areas, application, analysis and
evaluation of economic models is required as well as an
ability to assess policies that might be used to address
national and global economic challenges. Students should
develop an awareness of trends in the global economy over
the last 25 years through wider reading and research so
that they can include relevant examples in their analysis
and evaluation.
Students are encouraged to use an enquiring, critical and
thoughtful approach to the study of economics and to
develop an ability to think as an economist.
To develop their skills, knowledge and understanding in
economics, students need to have acquired competence in
quantitative skills that are relevant to and applied in the
context of this theme (see Appendix 3: Quantitative skills).
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