AQA ECON 3 Business Economics and the Distribution of Income

Introduction

The ECON 3 Exam focuses on Microeconomics and builds upon knowledge from

ECON 1. The main difference in ECON 3 is the need for evaluation and greater

application to the wider context. This Revision Booklet will summarise each of

the key areas in the specification, with some links to the UK and Global

Economy. In order to be fully up to date for the exam, it is important to research

current economic events beforehand. A full list of websites can be found on our

‘Links’ page, or you can follow @revisionsheets on twitter for articles that match

your specification.

Topics

- The Objectives of Firms

- Efficiency and Equity

- Perfect Competition

- Monopoly and Monopsony

- Oligopoly

- Contestable Markets

- Privatisation and Regulation

- Competition Policy

- Cost Benefit Analysis

- Poverty

- Wage Determination

- Monopsony Employers

- Distribution of Income

Note: Some elements of the

booklet have been covered as

this is a SAMPLE edition only.

To view the whole booklet,

please purchase a copy from

the website.

Factors of production are combined to create output. These factors are supply side, and

create costs. The output is a demand side component, and produces revenue.

A firms production costs are measured as the opportunity cost of the factors of

production used.

The Short Run is defined as the period of time in which at least one factor is fixed.

Usually Capital

Labour is usually regarded as a variable factor.

The Long Run is the period of time in which all factors are variable in quantity and in which

it is possible for the firm to move to a new scale of production.

The Marginal Product of Labour is the additional stock produced by adding one extra

worker, assuming all other factors are fixed. This is the only way to increase output in the short run.

As more labour is added, the marginal product of labour will rise, due to gains from

specialisation.

Gains from Specialisation:

Workers assigned to tasks in which they’re well suited.

Works learn by doing and efficiency improves through experience

Production line methods eliminate the need to change tools and this saves time.

Production line methods may make it cost effective to provide capitalist equipment.

The Law of Diminishing Marginal Returns states that as

the gains from specialisation are exhausted, the additional output from extra workers begins to diminish.

As more workers are added to a given stock of fixed factors, first the marginal product of labour and then the average product will eventually decline.

The Average Product of Labour is the total output divided

by the number of workers used.

Fixed Costs do not vary with output. They must be paid in the short run even if no output

is produced. E.g. Rent.

Variable Costs Vary in proportion to output. E.G. Electricity and Gas

Total Costs are calculated by adding Fixed and Variable Costs.

Marginal Cost is the cost of producing one extra unit

Average Costs are Total Costs / Total Output

Key Points:

The Marginal Product of Labour and Marginal Cost are mirror images

The Average Product of Labour and Average Variable Cost are mirror images

In the long term, all factors are variable. This means that a business can move into a new scale

of production. They will move onto new Short Run Average Cost Curves as they alter the

factors of production. The diagram above shows the transition in the short and long run. Overall, the

business suffers diseconomies of scale. This means that their average cost begins to go up, as their

output increases. Diseconomies of scale happen due to a lack of control, co-ordination or co-

operation at a greater scale.

The Minimum Efficient Scale is the minimum possible output required to achieve the full

potential of economies of scale. If output is increased past this point, the benefits of scale decline.

Internal Economies of Scale are either technical economies, marketing economies,

managerial economies, financial economies and risk-bearing economies – they are the result of

growth within the firm itself.

Technical Economies

This relates to the ability to produce and distribute easier on a greater scale.

Example: A large supermarket can reduce AC by using a barcode scanner, however a

corner shop couldn’t.

Marketing Economies

Larger firms have monopsony power that allows them to purchase their input

factors at a lower cost.

It also means they can spread their advertising budget over a larger output.

Managerial Economies

Bigger companies can afford specialists through the division of labour, which cut

operational costs and increase productivity.

Long Run Average Cost Curves

A

A

AA

LR

Output

Average Cost

Economies of Scale as output increases Diseconomies of Scale as output decreases

Minimum Efficient Scale (MES)

The diagram illustrates the area of revenue

produced when price is multiplied by

quantity.

As the price rises to P2, the quantity

demanded falls from Q1 to Q2. This

causes the area of revenue marked ‘3’ to

be lost. However, the area revenue

marked ‘1’ is then gained.

The amount of revenue change due to a price increase depends on the elasticity of the good. If the

good is very elastic, then the gain in revenue from the higher price will be negligible compared to the

loss of revenue from quantity. However, if the good is inelastic then the gain in revenue will rise after

a price change.

Marginal Revenue is the addition to revenue of adding one extra unit of the good or service.

Average Revenue is the total revenue divided by the quantity sold.

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The objectives of a firm are viewed differently by different people. Neo-classical theory

suggests that firms are controlled by shareholders and are profit maximisers in the short

run, where their Marginal Cost (MC) = Marginal Revenue (MR). In the long run, these firms

leave the market if their Total Revenue (TR) isn’t greater than or equal to their Total Cost (TC).

Neo-Keynesians believe that firms are long run profit maximisers. They set prices based

on the average total cost (ATC) of operating at full capacity and add a mark-up. Their argument is

that consumers like stable prices, and changes in the short run will damage a firm’s

reputation. Price increases are viewed as the firms making more profit, and price

decreases viewed as weakness in the firm. They view the long term position is

important, and may even sell at a loss in the short run to protect the long run position. A firm

should only change prices in response to: A long run change in cost conditions, or

during a recession. Firms undergo a long term strategy of market growth/dominance.

Managerial theories assume managers act to maximise their own utility, rather than

to meet the shareholders objectives. Pay, fringe benefits and career progression take

precedence over the firms (shareholders) best interests.

Satisficing in the concept of doing just enough to satisfy a key stakeholder, but not

necessarily doing everything that could be done. For instance, a manager in a firm may run the

business so that it satisfies shareholders, whilst at the same time sacrificing meeting all

the shareholders objectives in order to maximise his own utility (e.g. career progression).

Profit is Total Revenue minus Total Cost. It is the reward to factor of production ‘enterprise’.

Normal Profit is where just enough revenue is generated to cover the money costs of production and the

opportunity cost of the factors of production that have not been paid for. In the long run, if a firm is not making

at least a normal profit it will close and release it’s factors of production to be used elsewhere.

Supernormal Profit is any economic profit greater than zero. The factors of production are generating

more revenue than they could do in any other use.

Normal Profit TR = TC Supernormal Profit TR > TC

Firms are assumed to be profit

maximisers. They are

expected to behave like any

economic agent, and act

rationally.

Profit Maximisation for a

firm is at the point where its

Marginal Revenue equals its

Marginal Costs (MR = MC).

The diagram illustrates that at

quantity Q1 Marginal Revenue

exceeds Marginal Costs (MR >

MC). Here, a firm can

increase output to increase

profit.

At point Q3 Marginal Revenue is less than Marginal Cost (MR < MC). To increase profit here the

firm would need to reduce the level of output. Therefore, the profit maximising position is point

Q2, where Marginal Revenue is equal to Marginal Cost.

The Function of Profit

1. Reward for enterprise, acts an incentive to take risks and innovate – creating dynamic

efficiency in the economy.

2. Allocates resources through the price mechanism (incentive function)

3. Acts as an incentive to reduce x-inefficiency

4. Acts as a source of finance and incentive for investment

The Divorce of Ownership and Control occurs when those that control the business, do

not own the business. It creates a situation where individual objectives may come before

those of the shareholders. This becomes increasingly apparent as a firm grows. Sole Traders

and Partnerships involve the same people owning and controlling the business, meaning

there is no divorce of ownership. However, in limited companies this becomes more apparent. In a

Public Limited Company (PLC) shares are sold frequently on the stock market, and the owners can

become very distant from those that control it.

Sometimes, maximising Revenue

is seen as more important than

maximising Profit. This is often due

to Divorce of Ownership and

Control, where the manager has

more incentive to maximise

revenue than profit. For instance, a

manager’s bonus package may be

related to the total sales

revenue of the firm.

The revenue maximising point

is shown on the diagram at Q2. Here

Marginal Cost is equal to 0 (MR =

0). By producing at this level the firm

is making an economic loss, but maximising its revenue.

At point Q3, a firm is making its maximum revenue whilst generating a normal profit. By

expanding output further, the firm begins to make an overall loss.

Evaluation: The Divorce of Ownership and Control

1. Imperfect information to shareholders may mean they are unable to effectively judge

managers performance, and if they’re acting in the interest of the firm.

2. The level and type of incentive offered to managers to ensure they profit maximise effects the firms conduct and performance

3. The size of the firm is relevant to its conduct, as the link between a divorced owner and

manager grows as the firm expands.

4. A misallocation of resources can occur as the firm is not allocatively efficient at the

point of Revenue or Sales maximisation.

5. Shareholders often want the share price to rise in the short term, and ignore the

long term position. The divorce of ownership and control allows the shareholder to

distance themselves from the impartial running of the firm, from a long term perspective.

Short Termism can also effect safety, as corners are cut to profit maximise. This profit

maximisation could also lead to unreasonable stress being put on staff to cut costs and increase

productivity. This aspect however, could be countered through

Technical Efficiency involves

producing a given output at the

lowest possible average cost. All

points along the Long Run Average Cost

(LRAC) curve are technically

efficient.

Technical Inefficiency is also known

as x-inefficiency. It occurs when

there is a waste in the production

process, meaning average costs are

unnecessarily too high. All points

above the LRAC are x-inefficient

Causes of x-inefficiency:

- Weakness in the organisation of production and management

- Lack of competition, allowing firms to survive without striving to reduce costs.

- Lack of profit motive, e.g. in the Public Sector where operations aren’t profit driven

- Divorce of Ownership and Control

Productive Efficiency entails producing at the

lowest average costs for any level of output.

- It’s the point where all available internal

economies of scale are being

exploited

- Many firms can achieve lowest costs at a

range of outputs

Economic efficiency is referred to as the relationship between the inputs (factors of

production) and the output they produce.

The main objective in economics is to allocate resources to produce the most utility at the

lowest production cost.

Cost

Output

Minimum Efficient

Scale is the lowest

scale of production that

allows all internal

economies of scale to be

exploited.

Different industries have

different minimum

efficient scales.

Static Efficiency regards efficiency at a specific point in time.

Dynamic Efficiency regards efficiency in the future.

Equity is a normative measure (judgement) that relates to fairness, whereas Efficiency was a positive

concept measuring economic capability. Market performance is assessed from using both

Equity and Efficiency.

Horizontal Equity measures fair treatment across a range of people with homogeneous

circumstances.

Vertical Equity measures fair treatment across a range of people with different circumstances.

Equity ≠ Equality: Market systems do produce inequality of income, however, and many people find the

degree of inequality to be unfair. This unfairness can be translated into incentive, with people striving to

achieve what others achieve. For instance, the income inequality between highly skilled labour and unskilled

labour acts as an incentive for the unskilled worker to train.

By intervening to reduce inequality, the consequences for economic incentives may suffer causing

inefficiency. This balance is referred to as the equity-efficiency trade off.

Perfect Competition

Perfectly competitive markets have 0% concentration. The market is made up of many buyers

and sellers, none of which have any price making power.

Each firm’s product is identical, with homogeneous products.

Each firm and consumer has perfect knowledge of market conditions

No entry or exit barriers – complete freedom for firms to enter and leave the market.

Firms are profit maximisers

They produce output at a level where their Marginal Costs = Marginal Revenue

All firms are price takers, as they are forced to accept the market price

o As goods are homogenous, there are perfect substitutes for each other

o As information is perfect, consumers could switch products if the price was more

competitive.

o Therefore, the firm faces perfectly elastic demand

No monopsony power

No non-price competition of any kind, e.g. branding.

For the price mechanism to allocate efficiently, the market must be perfectly

competitive. Economic agents can only respond to

price changes effectively if they have perfect

information.

Supernormal Profit attracts new firms into the market;

it acts as an incentive function. Total Revenue

must exceed the opportunity cost of keeping the

factors of production in their present use to make

supernormal profit.

The diagram illustrates where supernormal profit is made. The AR=MR level, decided by the

market ruling price, intersects the MC curve at point Q. Total Revenue therefore is

calculated by P1 x Q. Total Cost is calculated by P2 x Q (AC x Q). Consequently,

supernormal profit occurs when Total Cost is subtracted from Total Revenue.

Once Supernormal Profit occurs, and new entrants are incentivised to come to the market –

supply shifts to the right.

This leads to a reduction in the market ruling price, and the level of AR = MR. Total

Revenue is now equal to Total Costs, making only a normal profit (already included in the

AC Curve). Quantity has also moved from Q1 to Q2, in response to the Supernormal Profit

generated by high demand. More resources are being allocated to make the product,

following consumer demand. They are being used where they maximise utility, making it

allocatively efficient.

Efficiency in Perfectly Competitive Markets

The Equity-Efficiency trade off may suffer in this market. A perfectly competitive

market ensures there is not much economic disparity, and therefore very little incentive.

Equity is high; however dynamic economic performance is likely to suffer.

In a perfectly competitive market, if a firm was not productively efficient it would suffer

losses. In the long run, the firm would leave the market and the resources allocated

elsewhere.

If a firm was technically inefficient (x-inefficiency), it would be unlikely to survive in a

highly competitive market. The reward of profit acts as the incentive to eliminate

waste.

Dynamic efficiency, however, is rarely experienced in a highly competitive market.

The freedom of entry discourages the need for innovation, and the lack of long term

supernormal profits prevents the investment in R&D needed to be dynamic. Efficiency

of this kind in this market is only experienced where competition is not perfect, only high.

In the long run if a firm is failing to make a

normal profit, it will reach its Shutdown

Point. It may continue to operate in the

short run to try and cover its variable

costs, while still contributing to its fixed

costs.

The diagram shows that at P1 the firm is

operating below its AVC curve, and consequently would not be operating here.

At P2, the firm is meeting its variable costs and contributing to its fixed costs. This is

the level at which a firm would be operating at in the short run, to reduce overall losses. In

the long run, the firm would shut down however, as a normal profit is unattainable.

At P3 both the variable and fixed costs are being met, so the firm would stay in business.

Supernormal profit isnt being made, but normal profit is.

In a monopoly market, there is a sole supplier. The entry barriers are high enough to

prevent new market entrants, the market is 100% concentrated.

As there are no substitutes for their products, monopoly firms exercise price making

power. The demand curve is inelastic, allowing them to raise the price without a significant

contraction of output demanded. Both total revenue and product subsequently rise. However, the

monopolist only has control over either the price or output, it cannot raise both. If it intends to

raise its price it must restrict output. This is described as being constrained by the demand

curve.

As there are high entry barriers, firms are able to maintain supernormal profits in the long run.

This means there is no difference between their

short and long run equilibriums.

The level of abnormal profit made illustrated

through the shaded area. It is the difference

between Average Revenue and Average Costs (AR-

AC).

Another argument against Monopolies is the

negative impacts on efficiency. As

monopolists restrict output, resources are not allocated efficiently. Productive

efficiency is also affected, as firms sacrifice economies of scale through restricted output.

A loss of welfare is also created in a monopoly

market, compared to one that’s perfectly

competitive.

Where competition is perfect, output is

produced at point Q1. Here the blue, green and

purple areas represent consumer surplus. As

a monopoly restricts output to Q2, consumer

surplus is reduced to just the green and purple

areas. Within this, the green area represents

supernormal profit made by the firm, leaving only the purple area as consumer

surplus. The loss of the blue area is described as a deadweight welfare loss. Critique: The

diagram doesn’t take into account the fact that monopolies could be experiencing large economies of

scale, and subsequently be producing at lower costs and higher outputs than in perfect competition.

Growth and Development

There are two types of growth – internal and external. External growth is usually through

merges and takeovers. This usually occurs when the firm wants to acquire a greater market

share. This could allow the firm to achieve greater economies of scale, acquire a valuable brand

name or gain greater control over the supply chain.

Internal growth is often referred to as organic growth, and comes about as firms expand their

operations or diversify into new product ranges. From this firms can generate higher sales by

exploiting possible economies of scale.

Integration occurs when two firms merge. Horizontal integration involves two firms joining

at the same stage of production in the same industry. Vertical integration

involves a firm developing market power by integrating with different stages of production

in an industry (e.g. the oil industry).

Monopolies can also develop through the creation of a statutory monopoly. This usually

involves firms being awarded patents for a period of time, or regional utility companies being given

monopoly status. Similarly, franchises and licenses such as radio and television licenses

present firms with monopoly power for a limited time.

Equity is another aspect to consider when assessing monopoly. The consumer is faced both

with a lack of choice, and the threat of being exploited by the monopolist’s price making

power. This power can lead to an unfair distribution of income.

Monopolies can also bring benefits to the market. As they produce a supernormal

profit, they are able to fund research and development. In the long run this creates

dynamic efficiency in the economy. Firms seeking monopoly power also act in a socially

beneficial way, e.g. creating customer loyalty by sponsoring community events.

Factors that contribute to price making power:

- High market concentration

- High barriers to entry

- Imperfect knowledge

- Imperfect knowledge

- Consumer inertia

- Product differentiation

Price discrimination is where firms charge difference prices to

different consumers for the same product/service.

Firms may sell off parts of the business if it becomes too difficult to manage, or if they

experience diseconomies of scale. This is called a demerger, and often allows the

firm to focus on its core business more effectively.

Surviving against Monopolies

First Degree Price Discrimination

- The firm charges the maximum price each consumer is

willing to pay

- All consumer surplus is turned into additional revenue

- Unlikely to occur as the firm needs to know each

individuals preferences

Consumer

Surplus =

Revenue

Second Degree Price Discrimination

- Occurs where firms sell excess units at a lower price

- E.g. Airlines and Hotels, where fixed costs are high but

marginal costs are minimal

- The firm can sell the remaining units at a lower price at

the end, without making a loss

A monopsony is a sole buyer of a good/service in a market. Common examples are large firms

such as Supermarkets who have the power to drive down the prices from their suppliers

as they buy in such large quantities. They can act to counter the effects of monopolies in a

market. Resource allocation is improved as prices are driven down to normal profit

levels. However, the power monopsonists have in driving down supplier costs can have

consequences on suppliers such as farmers that are seen as unfair. There are equity

considerations to assess.

Third Degree Discrimination

- This is where price is discriminated in

different segments of the market. For

instance Time, Area or Age

- In a peak market, demand is more

inelastic so firms charge higher prices

- Off peak markets demand lower

prices as its more elastic

Evaluating Price Discrimination

Consumers that buy the good at a lower

price due to minimising consumer surplus

will benefit

Allocative efficiency is not achieved is P>MC

The discrimination acts in the interest of

firms desiring higher profits

Profits from one service in a market could

be used to cross-subsidise socially

beneficial services in different markets

The market structure referred to as an oligopoly is one in which the market is made up of a

select few firms. These firms compete with each other, but block new entrants.

Firms offer differentiated products to the consumer, as a pose to homogenous goods found

in perfectly competitive markets.

Examples include Supermarkets, ‘The Big 4’ Accountancy Firms, Electricity Generation and Digital Television.

Firms in an oligopoly can either compete or collude. If they compete, they often undertake price

wars. They are interdependent, and their activity in the market largely involves responding to their competitors. If one firm reduces their prices, others generally follow in order to

remain competitive.

Competitive oligopolies are generally good news for the consumer. Prices are forced

down through competition and output is higher. Factors favouring competitive oligopoly:

One firm has significant cost advantages

Firms can only grow further through taking market share

New market entry

More firms

Homogenous goods being produced

Collusive oligopolies are generally bad news for the consumer. Prices are forced up

through informal/ formal agreements and output is lower. Factors favouring collusive oligopoly:

High entry barriers

Failing competition legislation

Consumer loyalty

Few firms

Similar costs between firms

The stability of the market often influences the nature of an oligopoly. If markets are stable

collusion may prosper, whereas in volatile markets competition is more likely to give

firms reasons to compete.

Market failure occurs during collusive oligopolies, as the market is allocatively inefficient. In competitive oligopolies markets work well.

Demonstrating Interdependence

The kinked demand curve illustrates how firms in

this market are interdependent. The curve assumes that

in the event of a price rise other firms do not

follow suit, and in the event of a price reduction

other firms do follow suit. If a firm raises its

price above point P it’s facing an elastic demand

curve, meaning its total revenue and profits will

fall. The same applies with firms reducing its price

below point P, facing an inelastic curve, and

revenue and profits falling. The model makes

assumptions on how the firms will interrelate.

Another way to show interdependence is through a cartel. A cartel is a group of firms that

collude to agree on a price and output level. An example is OPEC, the Oil and Petroleum Exporting

Countries. Whether or not parties stick to their agreements in a cartel causes them to be

interdependent. Generally, all involved parties benefit most if everyone sticks to the

agreements, however individual parties will prosper if they are the only ones to cheat.

The concept of first movers again portrays the interdependent nature of this market. Whether or

not a firm chooses to be a first mover (first significant entrant to the market) is a

strategic decision. The benefits of making the first move include: Establishing a reputation,

taking control of scarce resources and exploiting charges customers may face if they later

switch. Disadvantages include: Free rider effects (other firms copying) and late movers have

more time to assess the market.

The driving force behind a firm’s productivity is the threat of competition. The threat of new

entry affects the behaviour of incumbent firms.

A highly contestable market is one that is open to new entrants:

Low barriers to entry

Negligible sunk costs

Potential for supernormal profit

Perfect Competition and Monopolistic Competition are examples of perfectly

contestable markets. They have no entry or exit barriers. Monopolies can also be

perfectly contestable, if there is a single firm but an absence of barriers

Assuming the theory of contestable

markets is correct; firms implement limit

pricing to undercut competitors. A monopoly,

for instance, may have to reduce its price to

normal profit levels, to prevent new entrants.

The diagram shows profit maximisation

for a monopoly at P1;Q1. If a new firm is

looking to enter the market, the monopoly may

have to lower its price to P2 in order to

undercut them. Here, supernormal profit would not exist, and the new firm is unlikely to still be attracted to enter the market.

Barriers to Entry include:

1. International Trade Restrictions

2. Patents

3. Advertising

4. Sunk Costs

5. Limit Price 6. Absolute Price Advantage

7. Vertical Integration

Enhancing Contestability

1. Second Hand Markets

2. Deregulation

3. Diversifying from other markets

The height of entry barriers reflect the level of supernormal profit that can be made. A

market with high entry barriers, deffering new entrants, allows the potential for high

amounts of supernormal profit.

Artificial entry barriers are sometimes created to reduce the risk of new firms

entering the market. A common example is Advertising. Spending large amounts on

adversiting to create a brand and win customer loyalty makes an unknown new competitors

unlikely to succeed. These techniques restrict contesability, and can sometimes be a

matter for the competition commision.

Hit and Run competition occurs when firms quickly enter and leave a highly contestable

market. New firms can enter and grab some of the industry’s supernormal profit before

the dominant firms have time to react e.g. using predatory pricing. Double Glazing is a

prime example. New firms frequently enter and then leave the market – competing against

household names such as Everest.

Contestable Markets force competitive pricing, so their performance is very

similar to that of perfect competition.

The concepts of Privatisation, Deregulation and Internal markets aim to reduce the

role of the state within markets, whilst still ensuring economic efficiency.

Privatisation is the transfer of economic activity from the public sector to the private sector.

The Sale of Nationalised Firms

- BT

- British Gas

Competitive Tendering

Where firms compete by

bidding for the contract

Contracting Out

- School cleaning

- Hospital catering

Sale of State owned Assets

- Council houses

- Land

Private Finance Initiative

Where the state commissions private sector companies

to pay for and build new public services such as schools

which are then leased to them on a long term basis.

The main reason for privatising services is to make them more efficient. As private firms have

a profit motive, they aim to reduce x-inefficiency more so than public firms would. Private

firms however do still produce some waste, e.g. Monopolies, divorce of ownership and

control.

Privatisation improves resource allocation as private firms respond to market signals.

However, there are risks with privatising firms. For instance, firms that were once state

monopolies can become private monopolies, and use the price making power to exploit the

consumer. Governments may wish to deregulate the market at the same time to lower

barriers to entry and encourage new entrants.

Other issues such as safety and quality are also affected as firms become privatised. With the

profit motive being the main objective, other important aspects of the process may suffer.

The Private Finance Initiative (PFI) has a variety of pros and cons. Although the government

has no upfront costs, the rent payments may exceed the cost of borrowing and buying

upfront in the long term. Equitable issues such as the fairness on future generations’

taxpayers footing the bill also need to be considered.

For Against

Poorly performing services do not survive Poorly performing services deprived of resources

Quality is driven up due to competition Market failure may arise - asymmetric information

Window dressing can occur Monopoly power gained if no nearby substitutes

Price competition may improve efficiency Travel distances for consumers may be large

Reduced x-inefficiency will reduce costs

Deregulation involves the reduction of entry barriers to markets by the removal

of legal restrictions. In recent years a number of statutory monopolies have been opened up

to new competition. For instance, gas and electricity supply.

Resource allocation is improved by deregulation, as marginal revenue of firms is reduced

relative to marginal cost. Deregulation lowers entry barriers, and makes markets more

contestable. This, in conjunction with new firms actually entering, reduces the power of

monopolies and lowers prices. Price becomes closer to Marginal cost (P=MC being needed for

Allocative efficiency)

When a monopoly is privatised, deregulation is needed in order to prevent exploitation of the

consumer. If deregulation of the market is not possible, government regulation of the specific

monopoly is needed to ensure the consumer is treated fairly.

Natural monopolies are difficult to deregulate, as the industry can only cope with one firm.

The gas, water and electricity industry are common examples.

Internal Markets are created by governments to create competition within public

services. This idea was introduced by the Conservatives in the 1980’s (Thatcher). An example

is where schools and hospitals compete for custom, and their funding is dependent on

success.

Consumer sovereignty determines the allocation of resources. Example: GP’s have to run their

practise like a business. Every time they send a patient to use hospital services, they pay the

hospital for it. This increases economic efficiency in theory, however much of the funding is

then wasted on administrating it.

In a failing market, governments intervene. An example of this is through Competition Policy. The government regulates the market in this way to make them operate more

efficiently, and allocate resources more effectively.

The regulating body in the UK that assesses competition is the Competition Commission.

They act in the public interest, regulating to ensure the consumer is treated fairly.

Competition policy, like any government intervention, is not always successful. The

competitiveness of UK markets has increased in the past few years, mainly due to tightening

competition policy. The effectiveness of policy is often due to the information

available to the authorities. The authorities must first define the market, before they can

assess its concentration. Having a market too broad or too narrow won’t enable them to

effectively investigate if the consumer’s best interest is affected.

Competition Issues

Implicit Collusion is an issue in oligopolistic markets that the commission watches out for. It

is referred to as a restrictive practise, defined as a measure taken by a firm to limit

competition in its market. If the commission deems certain practises act against the public

interest it issues remedies. These aim to make the market function more effectively.

The allowance of a merger or takeover is assessed against the public interest too. If the

combined firm would have greater than a 25% market share, the competition

commission can investigate its effects. If they find it to have negative implications on public

interest, they advise the government to block it.

Cartel agreements are classed as serious restrictive practises, and covered by EU

Competition policy. The European Competition Commission acts to prevent any anti-

competitive activity between two or more firms located in various member states. A

cartel agreement involves colluding firms agreeing output and price restrictions for each

company. An example of a global cartel is OPEC, the Oil and Petroleum Exporting Countries. There is

some debate between politicians around the world about whether or not to deem the grouping

illegal.

Nowadays, many public sector contracts are sold off to private firms. Bid rigging is the practise of

a group of colluding firms artificially inflating the price of the bid between them, taking

it in turns to win. Recently, it was reported that China and India are amongst the worst in the

world for this type of anticompetitive behaviour.

A Cost Benefit Analysis is a procedure particularly used by governments to evaluate

investment projects, which takes into account social cost and benefits.

Key Points

Used for large investment projects e.g. airport expansion

Takes account of private and external costs and benefits

Different to private sector investment appraisal (i.e. includes externalities)

Problem quantifying external costs and benefits

Political reasons for cost benefit analysis

A project is deemed commercially viable if its private benefits exceed its private costs.

A Cost Benefit Analysis however attempts to establish whether a project carries a net social

benefit (social benefit - social cost). Governments often chose to undertake a Cost Benefit Analysis

to improve resource allocation.

Method

1. Identify costs and benefits

2. Value each of them in monetary terms

3. Work out Social Benefits and Costs

Social Benefit = Private Benefit + External Benefit

Social Cost = Private Costs + External Cost

4. Find Net Social Benefit

Social Benefit – Social Cost

5. Assess whether the resources are being used in their most efficient use by reviewing their

opportunity cost

Evaluation

Based on the problems highlighted above, certain conditions are necessary when conducting a Cost

Benefit Analysis:

1. State clearly where it hasn’t been possible to place a monetary value on a cost or benefit

2. State the assumptions made, such as the discount rate used

3. Ensure the analysis is carried out independently and its assumptions are not biased by

political considerations

4. Conduct a sensitivity analysis looking at the effect on outcome if the assumptions vary.

Externality Valuation Method Difficulties

Air Pollution - Cost of treating respiratory illness - Cost of lost hours of work

- Doesn’t account for the impact of respiratory illness on the quality of life of those who suffer

Loss of Life - Remaining work years of life multiplied by average wage

- Ethical Concerns - Discounts value of leisure time

Multiplier effects - Estimate second round spending benefit

- Spending Leakages

Problems Valuing Costs and Benefits

Private Costs and Benefits are fairly easy to

value. However unforeseen costs and

externalities are harder to measure.

Problems Identifying Costs and Benefits

Lack of information available to governments to

identify accurately each cost and benefit

Examples:

Problems Valuing Costs or Benefits that May or May Not Occur

When assessing factors that may not occur, a probability of it occurring must be attached. This

probability is then multiplied by the cost should it occur, producing the expected value.

Problems Valuing Costs or Benefits that occur in the future

Costs for future scenarios are at a discounted rate to the costs in present time. Therefore, a rate of

discount must be chosen and determines the value of future costs to be included in the Cost Benefit

Analysis.

Cost of conducting the Cost Benefit Analysis

Administrative costs for a project like this can be extremely expensive, and is only worth it if it produces

relevant and useful information. If not, this could be a source of government failure.

In the UK, distributions of income and wealth are both unequal. Distribution of wealth is

significantly more unequal than the distribution of income.

Key Trends

- Tends to be skewed towards older people

- Older people have had more time to build up savings and other forms of wealth

- White men are wealthier than ethnic men

- Men are wealthier than women

Sources of Wealth

- Inheritance

- Savings

- Income

- Property

- Entrepreneurship

- Chance

- Divorce Settlement

Income is the flow of money to a factor of production.

Wealth is a stock of assets. For example: cars, houses, savings and shares.

Marketable Wealth: wealth which can be transferred among individuals such as housing.

Non-marketable Wealth: cannot be transferred between individuals for example life assurance,

pension funds.

Equity refers to fairness

Causes of Wealth Inequality

- Inheritance (poor family = little to inherit)

- Marriage (wealthy people tend to marry

other wealth people)

- Income Inequality (high earners re more

people able to buy expensive assets)

- Chance (lottery wins)

The Distribution of Income is how income is shared out between factors of production. It is

more equal than the distribution of wealth, and can be measured by factor of production, between

households and between regions.

The Lorenz Curve - A method of measuring the degree of inequality in the distribution of income and wealth is

the Lorenz Curve.

- Horizontal Axis = Cumulative % of population

- Vertical axis = Cumulative % of income earned

- 45 degree line = perfect equality i.e. the bottom 40% of population earns 40% of the income

- The greater the inequality the greater the curve will be below the line

- If inequalities exist the line falls below the 45 degree line

The Gini Coefficient

- A statistical measure of the degree of inequality shown on the Lorenz curve is the Gini Coefficient

- Ratio of the area between 45 degree line and the Lorenz curve divided by the total area below the 45 degree line

- (a / a + b)

- Perfect equality ratio of 0

- Perfect inequality ratio of 1

- Closer it is to 1 the more unequal the distribution of income is

UK Trends

The distribution has become more unequal in recent decades. This is due to:

- Reduction in top rates of income tax

- Privatisation lead to rise in executives’ pay

- Real value of benefits such as job seekers allowance fell

- Percentage of single parents households not in work doubled between 1975-2000

Causes of Income Inequalities between Households Impact of the state

- Free market would not provide benefits and inequalities would be large

- Government intervenes to lessen these inequalities

Wealth Inequality

- Wealthier household will be able to earn more through dividends and interest from their assets

Household Consumption

- Different household will have different numbers in employment

Skills and Qualification

- People with skills and qualifications will tend to earn more. These differ between households

Earning differences

- Part time workers earn less than full time

- White earn more than black on average etc

Government Intervention Methods

Taxation

- Progressive Taxation

Monetary Benefits

- Means tested e.g. Income support

- Universal e.g. child benefit

Direct Provisions of Goods/ Services

- Provision of education, health care to give all citizens equality of opportunity

- Funded through taxation

Legislation and Labour Market Policy

- National Minimum Wage, anti-discrimination policies

Absolute Poverty:

When an individual or households income is in sufficient for them to afford basic shelter,

food and clothing.

Relative Poverty:

When households/people are comparatively poorer to others

Increases as distribution of income gets wider

A rise in a country’s income will result in a fall in absolute poverty. However, relative poverty may rise

if those on high incomes benefit more than those on low incomes.

Causes of Poverty:

- Low wages

- Unemployment

- Longer Life Spans

- Single Parenthood

- Changing patterns of demand for labour

o Creates structural employment

Poverty Trap In some cases, the incentive to work is reduced or removed due to government policy. Governments

have a variety of objectives when setting economic policy, some of which conflict. In this case the

conflicting policies are equity and efficiency.

The government offers benefits to those out of work in an attempt to reduce poverty (increase

equity). However, in conjunction with the progressive taxation system we have in the UK, the

incentive to work can be demolished. Those living off benefits earn more than if they were to get a

job as this reduces their benefits and increases their tax contribution.

Measuring Poverty: - There is no official measure of poverty

- Joseph Rowntree foundation defines a household as being in poverty if it’s disposable

income less than 60% of the UK median income.

Tackling Poverty:

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Contraction of Labour

Demanded Creates

unemployment

Unemployment created

affects the young more

(lower MRP)

Raises costs for British

firms relative to foreign

competitors

Could be inflationary Doesn’t account for regional differences

Many receivers

of NMW are employed

by the state

A morale boost from

higher wages could lead

to a productivity boost

Firms have incentive to

train workers as they

have to pay them more

Recipients are disproportionately

female, reducing gender differentials

Helps counter the power of monopsonist

employers

Helps reduce poverty

Offers a greater

incentive to work

National Minimum Wage:

The National Minimum Wage is the lowest wage

an employer can legally pay a worker in the UK.

There is much debate over whether it is effective,

and it has a range of pro’s and con’s.

Currently in the UK:

- For Adults over 21 the rate is £6.08

- For Adults 18-20 the rate is £4.98

- For Children 16-17 the rate is £3.68

- For Apprentices the rate is £2.60

The Labour Market

Derived Demand occurs when the demand for a factor of production arises from the

demand for the output it produces. Labour is a derived demand - as the demand for

the product made by the firm rises, so does its demand for labour. Wages are the reward

to labour as a factor of production, for giving up their time. The Opportunity Cost would be the

time that could be spent doing something else.

Note: Employment rises and falls in accordance with the business cycle

Determinants in the Demand for Labour:

Price of labour

o A rise in wage rates greater than the rise in productivity will reduce demand.

Productivity

o As output per worker increases the more attractive labour becomes

Price of Substitutes

o If capital becomes cheaper firms may decide to subsidise labour with machinery

Supplementary Labour Costs

o Increasing National Insurance contributions will lead to a fall in demand for labour.

Marginal Revenue Product is the value of the physical addition to output arising from hiring one

extra worker or factor of production.

Marginal Revenue is the amount of extra revenue generated from one extra unit of labour

Marginal Product is the number of extra units of output a firm gains from one extra unit of

labour

The equilibrium point is established where the marginal cost of hiring another worker equals its

Marginal Revenue Product

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The Labour Supply

Labour supply is the total number of hours that labour is willing and able to supply at a

given wage rate. The Labour Force is defined as the number of people in work or

actively seeking paid employment and available to start work.

Influencing Factors: Net Advantage:

The overall rewards to a particular

occupation, taking into account both

monetary and non-monetary factors.

Adam Smith argued that this should be equal across the industries in which an occupation exists.

For instance, an engineer in one industry

should experience the same rewards as an

engineer in another.

However, this theory doesn’t apply to everyone and

isn’t a generic fit.

Monetary

Bonuses

Commission

Salary

Financial Security

Fringe Benefits

Non Monetary

Lifestyle

Job Satisfaction

Environment

Working Conditions

Training

Promotion

Security

Holidays

Determinants of Labour Supply

1. Availability of Training

2. Location

3. Level of unemployment

4. Overtime

Elasticity of Labour Supply

1. Skills and Qualifications

2. Length of Training Period

3. Monetary Factors

4. Time Period

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A monopsony employer is the sole employer of a particular type of labour. In the UK, the

main example of a monopsonist employer is the state, employing teachers and nurses. It occurs

if there is a lack of competition

on the demand side of the

market. Monopolists have power with

regard to price setting, so do

monopsonists.

Monopsonist employers have the

power to drive down prices, as

they are faced with the

occupational supply curve.

The Monopsonist can chose

anywhere on the supply curve,

however if it employs one more

worker it must offer a higher

wage rate to all its workers. This is due to the upwards nature of the slope. Marginal Cost

is therefore greater than the average cost of labour.

Monopsonists will only hire an extra worker, if that results in it adding more revenue than

costs. The Marginal Revenue Product must be greater than Cost (MRP > MC)

The firms equilibrium level of employment is at the point where MRP = MC. However, the

equilibrium wage is directly below and less than the MRP, at the point where it meets the

supply curve. The firm could pay a wage where MRP = MC without making a loss on the last

worker, however it has no need to.

Trade Unions act to seek better pay and conditions (such as fringe benefits) for their

workers. They do this through collective bargaining, with the group of workers pay decided

by a single negotiation. This results in an imperfect market, with the supply side being

uncompetitive.

When analysing trade unions, the assumption is made that it is a closed shop. This means

that every worker in the occupation is a member of a single union. The density of the

union in a closed shop is 100%.

The diagram illustrates the effects of a

trade union in a competitive

market.

In a competitive market, the market

clearing equilibrium is Wc;Qc.

A trade union demands wage Wtu,

above the clearing wage. This causes a

shift to the left of employment to

Qtu.

Where the Wtu rate meets the

supply curve, higher wages are needed to extend supply. The curve kinks upwards as

each additional worker requires higher pay.

The effects of the union are unemployment and an increased wage rate. The union’s success

is measured on the union mark up. This is the difference in wage rate between members

of the union and non-members doing the same/similar job.

In a market where both a monopsonist employer and a trade union are present, their

power counteracts.

The trade union demands a

wage rate higher than the

monopsonist would otherwise

offer. The monopsonist

therefore becomes a wage

taker.

The market clearing price is

represented by Wc; Qc.

There is a limit to how many workers will supply themselves at Wm+tu. After this point,

the incentive of higher wages is needed to attract new workers. The monopsonist is

faced with paying a higher wage to all its workers, making the MC curve greater than the

S=AC curve.

This additional marginal cost is illustrated through the effective marginal cost curve

shown in orange. It follows the Wm+tu curve until the point where no more workers will be

supplied at that rate. Then, it kinks and joins the MC curve, as costs raise more as each worker is

added.

The wage level Wm+tu and employment level Qm+tu are higher than they would be without

the involvement of the union. The closer the wage and employment levels are to the clearing

equilibrium, the more successful the trade unions influence has been.

Evaluation of Trade Unions

- Having higher wages may not have much impact on employment, if the labour demand is

inelastic.

- In a monopolistic market, as outlined above, trade unions can increase employment.

They act against the powers of monopsony that is present in most labour markets,

measured by the extent to which wages are below Marginal Revenue Product.

- Trade Unions aim to increase pay and conditions for workers, increasing their welfare. In

theory this welfare will translate into productivity – working in the firms favour. This

makes the workers more valuable, and less likely to be laid off.

- The need to switch jobs within an occupation in search for better conditions is lessened

in these markets, as trade unions ensure conditions are already satisfactory. This means

fewer workers need to be recruited and trained by the firms, cutting their costs and

eventually helping to save jobs.

Context Questions

Question 1 – Data Calculation and Comment - Simple Calculation using data tables

E.g. Index Numbers

- Highlight two significant points from the data

- Quote data when describing both points

- Full marks can be obtained from a simple description with data

- There is no need to give reasons for the data

Question 2 – Explain and Analyse a concept - Define a key term

- Include two examples of the key term

- Two thorough points of analysis with chain of reasoning

- Use of relevant economic diagram

There are more marks available than the total that can be given

Question 3 – Evaluate an economic case - Define key terms

- Draw on materials in the context to support your points

- Use background knowledge to drop in relevant facts and figures

- Apply wider economic knowledge to relate the point to another area of

economics throughout AS and A2

- Analyse each point through a chain of reasoning highlighting any possible

consequences

- Only make points that are fully explained, avoid short unsubstantial paragraphs

- Evaluate each point considering concepts such as elasticity and time period

- Acknowledge both sides of an argument

- Strong final conclusion, avoid repeating points

- Make a judgement on your strongest point and reasons for that

This must follow a good structure and include evidence of on-going evaluation to gain more than 15 marks.

Use the plan for Part 2 of the Essay Question on the following page to help structure

Marks Available:

5

Marks Available:

10

Marks Available:

25

Essay Questions

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