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A Level Unit 3: Business Economics and Economic Efficiency

Topics covered in this unit

1. Motives of a firm
2. Why and how do firms grow?
3. Introduction to market structures
4. Perfect competition
5. Perfect competition equilibrium
6. Monopoly
7. Oligopoly and game theory
8. Monopolistic competition
9. Comparing the monopolist and perfect competition
10. Government intervention to promote competition

Perfect competition equilibrium

Short-run equilibrium

In perfect competition firms are assumed to be profit maximisers. Firms will therefore produce where marginal cost is equal to marginal revenue (MC=MR). The price the firm charges is determined by the market because the individual firm is too small to influence price and is therefore a price-taker. Perfectly competitive firms can make super-normal profits in the short-run as shown in the diagram below. In this diagram the horizontal average revenue curve is shown to be above the average total cost at the point where MC=MR (point A). At Q1 the firm charges P1, but faces only average costs of P2, therefore it makes super-normal profit as indicated by the shaded area (P1, P2, A, B).

Short-run profit maximisation

Short-run profit maximisation

In the next diagram, the firm is making a loss at its equilibrium, profit maximising or loss minimising output, where MC=MR. The price charged per unit of output P2 is lower than average total cost, P1 and hence the firm makes a loss of P1P2CD.

Firm making loss under perfect competition

Firm making loss under perfect competition

Long-run equilibrium

If a firm were making super normal profits in the short-run, other firms would enter the industry eager to share these high profits. They would be able to do this as there are no barriers to entry in perfect competition. The entry of new firms stimulates an increase in supply from S1 to S2 establishing a price just low enough for firms to make normal profits.

Long-run equilibrium position of a firm in an industry facing short term super normal profits

Long-run equilibrium position of a firm in an industry facing short term super normal profits

If a firm were making losses, in the long-run, some firms would leave the industry as there are no barriers to exit. As a result of these departures total supply would fall from S1 to S2. Firms would continue to leave the industry until the whole industry returns to profitability. This can be seen in the next diagram. When the supply curve is at S1 the firm is making a loss. At S2 the supply curve is high enough to make normal profits.

Long-run equilibrium position of a firm in an industry facing short term losses

Long-run equilibrium position of a firm in an industry facing short term losses

In the long-run, competition ensures that the equilibrium occurs where the firm neither makes super-normal profits nor losses. This means average cost equals average revenue in the equilibrium.

Next: Compare the monopolist and perfect competition

Supply-Side Policies

Supply-side policies are those which improve jobs, low inflation and economic growth by improving the productive potential of the economy. Supply-side policies try to improve productivity and competition in domestic and international markets. There are various supply-side policies that a government can use.

1. Reducing tax burden
Income tax is a requirement. However, high tax rates on incomes may make workers less inclined to work hard and achieve higher levels of productivity. Also, high tax rates on profits may reduce incentive of firms to invest in new products and production methods if any additional profits they make are simply swallowed up by tax.
Therefore, governments recognize that cutting tax on incomes and profits can have a direct effect on efforts of workers and firms to produce more and output and be competitive.

2. Trade Union Reforms
Many of the traditional legal protections enjoyed by the trade unions have been taken away – including restrictions on their ability to take industrial action. The result has been a decrease in strike action in virtually every industry and a significant improvement in industrial relations.
Improved partnerships between trade unions and employers can make a big contribution to raising productivity and improving the flexibility of workers in their jobs

3. Privatisation.
This was the major supply side policy on the product market side of the 1980s. The privatisation of various large industries (telecommunications, electricity, gas, etc.) was designed to break up the state monopolies to create more competition. Of course, many of these privatisations simply turned public sector monopolies into private sector monopolies, but there have been efforts to introduce competition into these industries. You may have seen the numerous TV adverts by lots of companies selling gas and electricity. Some large companies were also privatised, so that they would be exposed to the rigours of the market. British Airways is an example.

4. Education and training.
Some would say that this is the most important of all supply side policies. Government spending on education and training improves workers’ human capital. They become better quality workers. Their productivity improves and so the LRAS curve shifts to the right. Economies that have invested heavily in education are those that are well set for the future. Most economists agree, with the move away from industries that required manual skills to those that need mental skills, that investment in education, and the retraining of previously manual workers, is absolutely vital. It should also be noted that improved training, especially for those who lose their job in an old industry, will improve the occupational mobility of workers in the economy.

5. Deregulation
Deregulation involves removing old and unnecessary rules and regulations on business. The removal of these regulations should reduce business costs and help to increase output and lower prices.

6. Encouraging new research and development
The government can provide funds to help firms to invest in new research and development of better products and production methods. It can also encourage firms to invest in R&D by giving them tax relief on the money they spend on it.

Effect of successful supply-side policy

A successful supply side shift. This is the desired effect of supply side policy instruments

Evaluation

The advantages

– Supply-side policies can help reduce inflationary pressure in the long term because of efficiency and productivity gains in the product and labour markets.
– They can also help create real jobs and sustainable growth through their positive effect on labour productivity and competitiveness. Increases in competitiveness will also help improve the balance of payments.
– Finally, supply-side policy is less likely to create conflicts between the main objectives of stable prices, sustainable growth, full employment and a balance of payments. This partly explains the popularity of supply-side policies over the last 25 years.

The disadvantages

– However, supply-side policy can take a long time to work its way through the economy. For example, improving the quality of human capital, through education and training, is unlikely to yield quick results. The benefits of deregulation can only be seen after new firms have entered the market, and this may also take a long time.
– In addition, supply-side policy is very costly to implement. For example, the provision of education and training is highly labour intensive and extremely costly, certainly in comparison with changes in interest rates.
– Furthermore, some specific types of supply-side policy may be strongly resisted as they may reduce the power of various interest groups. For example, in product markets, profits may suffer as a result of competition policy, and in labour markets the interests of trade unions may be threatened by labour market reforms.
– Finally, there is the issue of equity. Many supply-side measures have a negative effect on the distribution of income, at least in the short-term. For example, lower taxes rates, reduced union power, and privatisation have all contributed to a widening of the gap between rich and poor.

Demand-Side Macroeconomic Policy Instruments

In the previous lesson, we learned about macroeconomic objectives of governments. Macroeconomic policy instruments are those used by the government to achieve those objectives. Macroeconomic policy instrument are divided into:
– Demand-side policies
– Supply-side policies

Demand-side policies are used to manipulate aggregate demand in the economy. When demand-side policies are used, it affects the Aggregate Demand Curve. Supply-side policies are used to raise output and employment.

There are two types of demand-side policies:

1. Fiscal Policy

Fiscal policy involves changing the level of public spending and/or taxation to to affect the level of aggregate demand.
During an economic recession, increasing the aggregate demand for goods and services can help boost output and reduce unemployment. If private sector spending is too low, then the government can increase its own spending. This can be combined with cuts on taxes on people’s income and firms’ profits. This will give them more money to spend. However, there is a risk that they will simply save this extra money or spend it on imported goods.
Increasing public spending and/or cutting taxes to boost aggregate demand, output and employment is known as expansionary fiscal policy.

Expansionary Demand Side Policies

Effect of expansionary demand side policies

During a period of high demand-pull inflation, fiscal policy may be used to deflate the economy by reducing the aggregate demand. this involves reducing public spending and/or raising taxes. However, a deflationary fiscal policy may increase unemployment and reduce growth in real output.

deflationary demand side policies

Effect of deflationary demand side policies

Problems with fiscal policy
The use of fiscal policy to influence the level of demand in an economy has been criticized by many economists. They argue that fiscal policy has not worked in the past. Instead inflation and unemployment got much worse in many countries. This is because:

1. fiscal policy is cumbersome to use
It is difficult for a government to know precisely when and by how much to expand public spending or cut taxes in a recession, or cut spending and raise taxes during a boom.
Boosting aggregate demand by increasing public spending and/or cutting taxes may cause an economy to ‘overheat’. That is, demand may rise too much and too quickly. If the quantity of goods and services does not rise as quickly as demand, there will be demand-pull inflation. On the other hand, government may cut spending and raise taxes by too much following a period of high inflation and cause unemployment to rise.

2. Public spending crowds out private spending
To finance an increase in public spending and/or cut in taxes, the government may borrow from the private sector. When the private sector lends money to the government, the private sector has available to spend. This is called crowding out.

3. Raising taxes on income and profits reduces work incentives, employment and economic growth.
If taxes are too high, people and firms may not work as hard. This reduces productivity, output and profits.

4. Expansionary fiscal policy increases expectations of inflation
As a result, people will push for higher wages to protect them from higher prices in the future. Rising wages increases production costs and reduces demand for labour. This in turn causes cost-push inflation and rising unemployment.

2. Monetary Policy

Monetary Policy refers to actions taken by a government to try to control either the supply of money in the economy or the price of money. Interest rates are prices of borrowing money or reward for lending money.
Monetary policy works by changing the rate of growth of demand for money; changes in interest rates affect the spending and savings behaviour of households and businesses

How monetary policy works
Monetary policy involves changes in the base (policy) rate of interest to influence the growth of AD, the money supply, output, jobs and inflation.

monetary-policy-transmission

The following text is taken from Bank of England website as how it explains the use of monetary policy

When the Bank of England changes the official interest rate it is attempting to influence the overall level of expenditure in the economy. When the amount of money spent grows more quickly than the volume of output produced, inflation is the result. In this way, changes in interest rates are used to control inflation.

The Bank of England sets an interest rate at which it lends to financial institutions. This interest rate then affects the whole range of interest rates set by commercial banks, building societies and other institutions for their own savers and borrowers. It also tends to affect the price of financial assets, such as bonds and shares, and the exchange rate, which affect consumer and business demand in a variety of ways. Lowering or raising interest rates affects spending in the economy.

A reduction in interest rates makes saving less attractive and borrowing more attractive, which stimulates spending. Lower interest rates can affect consumers’ and firms’ cash-flow – a fall in interest rates reduces the income from savings and the interest payments due on loans. Borrowers tend to spend more of any extra money they have than lenders, so the net effect of lower interest rates through this cash-flow channel is to encourage higher spending in aggregate. The opposite occurs when interest rates are increased.

Lower interest rates can boost the prices of assets such as shares and houses. Higher house prices enable existing home owners to extend their mortgages in order to finance higher consumption. Higher share prices raise households’ wealth and can increase their willingness to spend.

Changes in interest rates can also affect the exchange rate. An unexpected rise in the rate of interest in the UK relative to overseas would give investors a higher return on UK assets relative to their foreign-currency equivalents, tending to make sterling assets more attractive. That should raise the value of sterling, reduce the price of imports, and reduce demand for UK goods and services abroad. However, the impact of interest rates on the exchange rate is, unfortunately, seldom that predictable.

Changes in spending feed through into output and, in turn, into employment. That can affect wage costs by changing the relative balance of demand and supply for workers. But it also influences wage bargainers’ expectations of inflation – an important consideration for the eventual settlement. The impact on output and wages feeds through to producers’ costs and prices, and eventually consumer prices.

Macroeconomic objectives of governments

From the previous lessons, we learned that governments can act in the economy to achieve optimum performance of the economy. In doing so, governments usually have four main economic aims:

1. to achieve low and stable inflation (price stability)
2. to maintain a high level of employment and low level of unemployment
3. to encourage economic growth
4. to encourage trade and secure a favourable balance of payments

There are other objectives which are increasingly becoming important for governments:

5. Equitable distribution of income and wealth – a fair share of the national ‘cake’, more equitable than would be in the case of an entirely free market.
6. Increasing Productivity – more output per unit of labour per hour. Also, since labor is but one of many inputs to produce goods and services, it could also be described as output per unit of factor inputs per hour.
7. Thermal Equilibrium – equilibrium in the Balance of payments without the use of artificial constraints. That is, exports roughly equal to imports over the long run.

Which of the above economic objectives are more important?

All of the above are objectives of governments (especially 1 to 4). However, governments at times may give more priority to a particular objective than the others. Let us look at historical preferences.

Growth and low inflation have always been important. Without growth, peoples’ standard of living will not increase, and if inflation is too high then the value of money falls negating any increase in living standards. Therefore growth is usually the most important objective of the government.

In the 1960s, the Balance of Payments was considered very important. A deficit was considered highly embarrassing in the days when many still believed, mistakenly, that Britain was a world power. The long-term sustainability of a deficit was a big problem in the days before global free movements of capital. Deficits would reduce the demand for the £ relative to other currencies, and so the value of the £ against other currencies would fall (see the topic called ‘Exchange rates’ for much more detail). This was unacceptable within the ‘Bretton Woods fixed exchange rate system’. Nowadays, with a floating pound and huge global capital flows, many economists believe that balance of payments deficits or surpluses (on current account) simply do not matter. This was reflected in the fact that nobody seemed to bat an eyelid at the continual deficits of the 90s.

Full employment was considered very important after the Second World War. It was probably the number one objective of the socialist government of the late 40s and continued to be at the front of politicians’ minds for the next three decades. Unemployment exploded under Thatcher in the 80s, but it was seen as an inevitable consequence of the steps taken to make industry more efficient. It was painful at the time but the lower levels of unemployment today are due, in part, to the structural changes made in the 80s.

Conflicts between macroeconomic objectives

It is quite often the case that the government will face conflicts between its various economic objectives. This is highlighted by the Phillips’ curve.

Philips Curve

Philips Curve

In this case, lower unemployment can be achieved at the cost of higher inflation and vice versa. Keynesian Aggregate Demand / Aggregate Supply analysis shares the same conclusion as the Phillips’ curve relationship. In the Keynesian analysis, unemployment is reduced as the economy moves towards the full employment level of national income, but this is achieved at the price of higher inflation – as seen in the Keynesian AD/AS diagram.
In general, the four government macroeconomic objectives can be split into two pairs of two that go together. Low unemployment and a good rate of economic growth tend to go together, but tend to conflict with the economic objectives of low inflation and a Balance of Payments balance. This is because the first two objectives would benefit from a high level of demand in the economy because this will mean more demand for workers to produce these goods that are demanded.
The economy will also tend to grow more rapidly in times of buoyant demand, because domestic producers will expand production to meet the high level of demand. (This is assuming of course that the economy has not reached full capacity). A high level of demand, however, may lead to increasing inflation and a current account deficit on the Balance of Payments. A high level of demand may lead to rising inflation, especially if supply cannot increase to satisfy demand due to supply constraints. Imports may also flood in to satisfy demand if it cannot be satisfied by domestic supply.

Low inflation and balance on the Balance of Payments will tend to be best achieved in times of lower levels of Aggregate Demand. When demand in the economy is low, demand for imports will tend to be low, improving the Balance of Payments situation. A low level of demand will also reduce the possibility of demand-pull inflation. However, in conditions of low Aggregate Demand, the government may find it difficult to achieve its objectives of low unemployment and economic growth. A low level of demand for goods and services will tend to reduce the demand for workers to produce these goods and services, meaning higher unemployment. Similarly, the economy is likely to growl less rapidly if there is a reduced demand for goods and services.

In the classical model of AS/AD, there is no conflict between the government’s economic objectives. Indeed, in this model an increase in AS will tend to achieve a higher rate of economic growth, lower unemployment and put downwards pressure on inflation all at the same time. Many classical economists argue that a low rate of inflation is a pre-requisite for the achievement of the government’s major macroeconomic goals.