Monetarism

Introduction

The Basics of Monetarism

The key features of monetarist theory are as follows:

1. The main cause of inflation is an excess supply of money in an economy leading to in the words of the late Monetarist economist Milton Friedman, “too much money chasing too few goods”
2. Tight control of money and credit is required to maintain price stability
3. Attempts by the government and the central bank to use fiscal and monetary policy to “fine-tune” the rate of growth of aggregate demand are ineffective. Fiscal policy has a role to play in stabilising the economy providing that the government is successfully able to control its own borrowing
4. The key is for monetary policy to be credible – in the hands of an independent central bank – so that people’s expectations of inflation are controlled

A simple way of explaining how a surge in the amount of money in circulation can feed through to higher inflation is shown in the flow chart above.

1. Excess money balances held by households and businesses can affect demand and output in several directions. Consumers will increase their own demand for goods and services adding directly to aggregate demand (although a high proportion of this extra spending may go on imports).
2. Some of the excess balances will be saved in bonds and other financial assets, or invested in the housing market. An increase in the demand for bonds causes a downward movement in bond interest rates (there is an inverse relationship between the two) and this can then stimulate an increase in investment.
3. Money that flows into housing will push house prices higher, and we know understand quite well how a booming housing market stimulates consumer wealth, borrowing and an increase in spending.

The Quantity Theory of Money

• The Quantity Theory was first developed by Irving Fisher in the inter-war years, and is a basic theoretical explanation for the link between money and the general price level.
• The theory rests on what is sometimes known as the Fisher identity or the equation of exchange.  This is an identity which relates total aggregate demand to the total value of output (GDP).

M x V = P x Y
Where

• M is the money supply
• V is the velocity of circulation of money
• P is the general price level
• Y is the real value of national output (i.e. real GDP)

Money supply (M) multiplied by the velocity of circulation (V) = the value of national output (price level (P) x volume of transactions (Y))

• Velocity of circulation represents the number of times that a unit of currency (E.g. a £10 note) is used in a given period of time when used as a medium of exchange to buy goods and services
• Velocity of circulation can be calculated by dividing the money value of national output by the money supply.

In the basic theory of monetarism expressed using the equation of exchange, we assume that the velocity of circulation of money is predictable and therefore treated as a constant. We also make an assumption that the real value of GDP is not influenced by monetary variables. For example the growth of a country’s productive capacity might be determined by the rate of productivity growth or an increase in the capital stock. We might therefore treat Y (real GDP) as a constant too.

• If V and Y are treated as constants, then changes in the rate of growth of the money supply will equate to changes in the general price level
• Monetarists believe that the direction of causation is from money to prices (as we see in the flow chart on the previous page).

The experience of targeting the growth of the money supply as part of the monetarist experiment during the 1980s and early 1990s is that the velocity of circulation is not predictable – indeed it can suddenly change as a result of changes to people’s behaviour in their handling of money. During the 1980s it was found that direct and predictable links between the growth of the money supply and the rate of inflation broke down. This eventually caused central banks in different countries to place less importance on the money supply as a target of monetary policy. Instead they switched to having exchange rate targets, and latterly they have become devotees of inflation targets as an anchor for the direction of monetary policy.

Measuring the money supply
There is no unique measure of the money supply because it is used in such a wide variety of ways. 

• M0 (Narrow money) - comprises notes and coins in circulation banks' operational balances at theBank of England. Over 99% of M0 is made up of notes and coins as cash is used mainly as a medium of exchange for buying goods and services. Most economists believe that changes in the amount of cash in circulation have little significant effect on total national output and inflation. At best M0 is seen as a co-incident indicator of consumer spending and retail sales. If people increase their cash balances, it is mainly a sign that they are building up these balances to fund short term increases in spending. M0 reflects changes in the economic cycle, but does not cause them.
• M4 (Broad money) is a wider definition of what constitutes money. M4 includes time and sight deposits saved with banks and building societies and also money created by lending in the form of loans and overdrafts.

M4 = M0 plus sight (current accounts) and time deposits (savings accounts).

Bank lending and the money supply

When a bank or another lender grants a loan to a customer, bank liabilities and assets raise by the same amount and so does the money supply. Again M4 is a useful background indicator to the strength of demand for credit.

The Bank takes M4 growth into account when assessing overall monetary conditions, but it is not used as an intermediate target of monetary policy

Its main value is as a signpost of the strength of demand which can then filter through the economy and eventually affect inflationary pressure. According to the Bank of England’s figures the amount of M4 money at the end of October 2010 was £2.19 trillion. To put this into some context, the GDP figure for 2009 was £1.4 trillion, so the amount of M4 is equivalent to about 1½ times GDP.

The Money Supply and Velocity during the Credit Crunch

Quantitative easing (QE) is a deliberate policy to boost the money supply and provide a stimulus to demand in a bid to avoid damaging price deflation.

Central banks both in the UK and the USA have certainly created a lot of money. The so-called monetary base, consisting of cash and the central banks’ deposits, has roughly doubled in the US and Britain since 2007.

However, shrinking private bank credit as the lending freeze brought about by the credit crunch has continued longer than expected has offset this.

As a result, growth in total money the world over has been slow. Put another way, most of the money ‘created’ by quantitative easing is sitting in banks’ reserves, rather than finding its way to businesses and consumers.

We are seeing a contraction in the money supply because of the credit crunch / fall in lending. If velocity of circulation is stable then this will lead to a fall in the value of GDP. Matters are made worse if velocity is also declining – households are starting to hoard cash as are companies worried about insolvency and the lack of credit and hedge funds holding onto cash because of fears over investors wanting to redeem their money.

International Trade - Introduction & Overview

What is Trade?

Trade is the exchange of products between countries
When conditions are right, trade brings benefits to all countries involved and can be a powerful driver for sustained growth and rising living standards.
One way of expressing the gains from trade in goods and services is to distinguish between static gainsfrom trade (i.e. improvements in allocative and productive efficiency) and dynamic gains (i.e. gains in welfare that occur over time from improved product quality, increased choice and faster innovative behaviour).

Gains from Trade – Understanding Comparative Advantage

First introduced by David Ricardo in 1817, comparative advantage exists when a country has a ‘margin of superiority’ in the production of a good or service i.e. where the marginal cost of production is lower
Countries will generally specialise in and export products, which use intensively the factors inputs, which they are most abundantly endowed.
If each country specializes, then total output can be increased leading to an improvement in allocative efficiency and welfare.
Because production costs are lower, providing that a good market price can be found from international buyers, specialisation should focus on those goods and services that provide the best value
In highly developed countries, comparative advantage is shifting towards specialising in producing and exporting high-value and high-technology manufactured goods and high-knowledge services.
Example of comparative advantage
Usually we take a standard two-country + two-product example to illustrate comparative advantage

• Consider two countries producing two products – digital cameras and vacuum cleaners
• With the same factor resources evenly allocated by each country to the production of both goods, the production possibilities are as shown in the table below.

OUTPUT BEFORE SPECIALISATION	Digital Cameras	Vacuum Cleaners
UK	600	600
United States	2400	1000
Total	3000	1600

Working out the comparative advantage

• To identify who should specialise in a particular product,  consider the internal opportunity costs
• Were the UK to shift resources into supplying more vacuum cleaners, the opportunity cost of each vacuum cleaner is one digital television
• For the United States the same decision has an opportunity cost of 2.4 digital cameras. Therefore, the UK has a comparative advantage in vacuum cleaners
• If the UK chose to reallocate resources to digital cameras the opportunity cost of an extra camera is one vacuum cleaner. But for the USA the opportunity cost is only 5/12ths of a vacuum cleaner.
• USA has comparative advantage in producing digital cameras because its opportunity cost is lowest.

Output after Specialisation

	Digital Cameras	Vacuum Cleaners
UK	0 (-600)	1200 (+600)
United States	3360 (+960)	600 (-400)
Total	3000 3360	1600 1800

• The UK specializes totally in producing vacuum cleaners – doubling its output  - now1200
• The United States partly specializes in digital cameras increasing output by 960 having given up 400 units of vacuum cleaners
• As a result of specialisation output of both products has increased - a gain in economic welfare.

For mutually beneficial trade to take place, the two nations have to agree an acceptable rate of exchange of one product for another. If the two countries trade at a rate of exchange of two digital cameras for one vacuum cleaner, the post-trade position will be as follows:

• The UK exports 420 vacuum cleaners to the USA and receives 840 digital cameras
• The USA exports 840 digital cameras and imports 420 vacuum cleaners

Post trade output / consumption

	Digital Cameras	Vacuum Cleaners
UK	840	780
United States	2520	1020
Total	3360	1800

Compared with the pre-specialisation output levels, consumers now have an increased supply of both goods

Key assumptions behind trade theory

This theory of trade based on comparative advantage depends on a number of assumptions:
Occupational mobility of factors of production (land, labour, capital) -this means that switching factor resources from one industry to another involves no loss of efficiency and productivity. In reality we know that factors of production are not perfectly mobile – labour immobility for example is a root cause of structural unemployment
Constant returns to scale (i.e. doubling the inputs used in the production process leads to a doubling of output) – this is merely a simplifying assumption. Specialisation might lead to diminishing returns in which case the benefits from trade are reduced. Conversely increasing returns to scale means that specialisation brings even greater increases in output.
No externalities arising from production and/or consumption – no discussion about the overall costs and benefits of specialisation and trade should ignore many of the environmental considerationsarising from increased production and trade between countries.
The standard model of trade focuses on trade between countries. In reality, most trade takes place between businesses across national boundaries – i.e. intra-industry trade. In the last twenty years we have seen huge changes in both the pattern of trade between developed and developing countries. And also the complexity of manufacturing supply chains around the world. Typically for example, a tablet computer or a smartphone will be manufactured in one or two centers but the components will have come from dozens of other countries.

Sources of Comparative Advantage

Comparative advantage is a dynamic concept meaning that it changes over time.

For a country, the following factors are important in determining the relative unit costs of production:

The quantity and quality of factors of production available for example some countries have an abundant supply of good quality farmland, oil and gas, fossil fuels. Climate and geography have key roles in creating differences in comparative advantage.

Different proportions of factors of production – some countries have abundant low-cost labour suitable for volume production of manufacturing products.

Increasing returns to scale and the division of labour – increasing returns occur when output grows more than proportionate to inputs. Rising demand in the markets where trade takes place helps to encourage specialisation, higher productivity and internal and external economies of scale. These long-run scale economies give regions and countries a significant advantage.

Investment in research & development which can drive innovation and invention

Fluctuations in the exchange rate, which then affect the relative prices of exports and imports and cause changes in demand from domestic and overseas customers.

Import controls such as tariffs, export subsidies and quotas – these can be used to create an artificial comparative advantage for a country's domestic producers.

The non-price competitiveness of producers - covering factors such as the standard of product design and innovation, product reliability, quality of after-sales support. Many countries are now building comparative advantage in high-knowledge industries and specializing in specific knowledge sectors – an example here is the division of knowledge in the medical industry, some countries specialize in heart surgery, others in pharmaceuticals.

Institutions – these are important for comparative advantage and important for growth too. Banking systems are needed to provide capital for investment and export credits, legal systems help to enforce contracts, political institutions and the stability of democracy is a key factor behind decisions about where international capital flows.

Comparative advantage is often a self-reinforcing process.

• Entrepreneurs in a country develop a new comparative advantage in a product either because they find ways of producing it more efficiently or they create a genuinely new product that finds a growing demand in home and international markets
• Rising demand and output encourages the exploitation of economies of scale; higher profits can be reinvested in the business to fund further product development, marketing and a wider distribution network. Skilled labour is attracted into the industry and so on
• The expansion of an industry leads to external economies of scale.
  

Wider Benefits of International Trade

Many countries have seen a growing share of their GDP directly linked to overseas trade, our chart below tracks data for India, one of the fast-growing BRIC nations. India joined the WTO in 1991.

Prior to joining the WTO, Indian trade as a share of GDP was low by global standards at just 15%. That figure has doubled in the last twenty years

Some of the broader gains from trade are:

Welfare gains: Supporters of trade believe that trade is a ‘positive-sum game’ – all counties engaged in open trade and exchange stand to gain

Economies of scale – trade and increased market size allows firms to exploit scale economies leading to lower average costs of production that might be passed onto consumers

Competition / market contestability – trade promotes increased competition particularly for domestic monopolies that would otherwise face little competition. Trade is a spur for higher productivity – a stimulus to higher business efficiency across many industries.

Dynamic efficiency gains from innovation - trade enhances choice and stimulates product and process innovations bringing better products for consumers and enhances the standard of living

Access to new technology and inflows of new knowledge: trade, like investment, is a mechanism by which countries can have access to new technologies. Trade is a stimulus to the exchange of ideas and inflow of human capital. Openness to trade allows imports of capital equipment at lower prices.

Rising living standards and a reduction in poverty - a growing body of evidence shows that countries that are more open to trade grow faster over the long run and have higher per capita income than those that remain closed. Growth through trade directly benefits the world's poor although free trade is not necessarily equitable

The UNDP believe that greater openness in trade can be a major factor behind reducing extreme poverty. For example in the case of Cambodia, access to markets is estimated to have contributed to a decrease in extreme poverty from 35% in 2002 to 25.8% in 2010.

Some quotes on the value of trade

“According to a recent study, one iPhone has an export value of $150 per unit in Chinese trade statistics but the value added attributable to processing in China is only $4, with the remaining value added assembled in China coming from the United States, Japan, and other Asian countries”

Pascal Lamy, Director-General of the World Trade Organisation

“The case for free trade is robust. It extends not only to overall prosperity or gross national product (GNP), but also to distributional outcomes, which makes the free trade argument morally compelling as well”

“The dramatic upturn in GDP growth rates in India and China after they turned strongly towards dismantling trade barriers in the late 1980s and early 1990s is compelling.

“In India, the shift to accelerated growth after reforms that included trade liberalization has pulled nearly 200 million people out of poverty. In China, which grew faster, it is estimated that more than 300 million people have moved above the poverty line since the start of reforms.”

Professor Jagdish Bhagwati

Buffer stock systems

          The prices of agricultural products such as wheat, cotton, cocoa, tea and coffee tend to fluctuate more than prices of manufactured products and services.

This is largely due to the volatility in the market supply of agricultural products coupled with the fact that demand and supply are price inelastic.

One way to smooth out the fluctuations in prices is to operate price support schemes through the use ofbuffer stocks. But many of them have had a chequered history.

Buffer stock schemes seek to stabilize the market price of agricultural products by buying up supplies of the product when harvests are plentiful and selling stocks of the product onto the market when supplies are low.

Analysis diagram for a buffer stock scheme

• The diagram below illustrates the operation of a buffer stock scheme
• The government offers a guaranteed minimum price (P min) to farmers of wheat
• The price floor is set above the normal free market equilibrium price
• Notice that the price elasticity of supply for wheat in the short term is low because of the length of time it takes for producers to supply new quantities of wheat to the market. (Indeed in the momentary period, we would draw the supply curve as vertical indicating a fixed supply).

If the government is to maintain the guaranteed price at P min, then it must buy up the excess supply (Q3-Q1) and put these purchases into intervention storage

Should there be a large rise in supply due to better than expected yields at harvest time, the market supply will shift out – putting downward pressure on the free market equilibrium price. In this situation, the intervention agency will have to intervene in the market and buy up the surplus stock to prevent the price from falling. It is easy to see how if the market supply rises faster than demand then the amount of wheat bought into storage will grow.

Advantages of a successful buffer-stock scheme:

• Stable prices help maintain farmers’ incomes and improve the incentive to grow legal crops
• Stability enables capital investment in agriculture needed to lift agricultural productivity
• Farming has positive externalities it helps to sustain rural communities
• Stable prices prevent excess prices for consumers – helping consumer welfare

Problems with buffer stock schemes

In theory buffer stock schemes should be profit making, since they buy up stocks of the product when the price is low and sell them onto the market when the price is high. However, they do not often work well in practice. Clearly, perishable items cannot be stored for long periods of time and can therefore be immediately ruled out of buffer stock schemes.  Other problems are:

• Cost of buying excess supply can cause a buffer stock scheme to run out of cash
• A guaranteed minimum price might cause over-production and rising surpluses which has economic and environmental costs
• Setting up a buffer stock scheme also requires a significant amount of start up capital, since money is needed to buy up the product when prices are low. There are also high administrative and storage costs to be considered.

The success of a buffer stock scheme however ultimately depends on the ability of those managing a scheme to correctly estimate the average price of the product over a period of time. This estimate is the scheme’s target price and obviously determines the maximum and minimum price boundaries. 

But if the target price is significantly above the correct average price then the organization will find itself buying more produce than it is selling and it will eventually run out of money. The price of the product will then crash as the excess stocks built up by the organization are dumped onto the market.

Conversely if the target price is too low then the organization will often find the price rising above the boundary, it will end up selling more than it is buying and will eventually run out of stocks 

Competition & Monopoly in Markets,IGCSE,GCEO

Introduction

A market structure describes the characteristics of a market which can affect the behaviour of businesses and also affect the welfare of consumers. Some of the main aspects of market structure are listed below:

• The number of firms in the market
• The market share of the largest firms
• The nature of production costs in the short and long run e.g. the ability of businesses to exploiteconomies of scale
• The extent of product differentiation i.e. to what extent do the businesses try to make their products different from those of competing firms?
• The price and cross price elasticity of demand for different products
• The number and the power of buyers of the industry’s main products
• The turnover of customers - this is a measure of the number of consumers who switch suppliers each year and it is affected by the strength of brand loyalty and the effects of marketing. For example, have you changed your bank account or your mobile phone service provider in the last year? What might stop you doing this?

What is a monopoly?

• A pure monopolist in an industry is a single seller. It is rare for a firm to have a pure monopoly – except when the industry is state-owned and has a legally protected monopoly.
• A working monopoly: A working monopoly is any firm with greater than 25% of the industries' total sales. In practice, there are many markets where businesses enjoy some degree of monopoly power even if they do not have a twenty-five per cent market share. 
• An oligopolistic industry is characterised by the existence of a few dominant firms, each has market power and which seeks to protect and improves its position over time.
• In a duopoly, the majority of sales are taken by two dominant firms.

How monopolies can develop

Monopoly power can come from the successful organic (internal) growth of a business or throughmergers and acquisitions (also known as the integration of firms).

Horizontal Integration 

This is where two firms join at the same stage of production in one industry. For example two car manufacturers may decide to merge, or a leading bank successfully takes-over another bank.

Vertical Integration      

This is where a firm integrates with different stages of production e.g. by buying its suppliers or controlling the main retail outlets. A good example is the oil industry where many of the leading companies are explorers, producers and refiners of crude oil and have their own retail networks for the sale of petrol and diesel and other products.

• Forward vertical integration occurs when a business merges with another business further forward in the supply chain
• Backward vertical integration occurs when a firm merges with another business at a previous stage of the supply chain

The Internal Expansion of a Business 

Firms can generate higher sales and increased market share and exploiting possible economies of scale. This is internal rather than external growth and therefore tends to be a slower means of expansion contrasted to mergers and acquisitions.

Barriers to Entry

Barriers to entry are the means by which potential competitors are blocked. Monopolies can then enjoy higher profits in the longer-term. There are several different types of entry barrier – these are summarised below:

• Patents: Patents are legal property rights to prevent the entry of rivals. They are generally valid for 17-20 years and give the owner an exclusive right to prevent others from using patented products, inventions, or processes. Owners can sell licences to other businesses to produce versions of their patented product.

• Advertising and marketing: Developing consumer loyalty by establishing branded products can make successful entry into the market by new firms much more expensive. Advertising can also cause an outward shift of the demand curve and make demand less sensitive to price

• Brand proliferation: In many industries multi-product firms engaging in brand proliferation can give a false appearance of competition. This is common in markets such as detergents, confectionery and household goods – it is non-price competition.

Monopoly, market failure and government intervention

Should the government intervene to break up or control the monopoly power of firms in market?

The main case against a monopoly is that it can earn higher profits at the expense of allocative efficiency. The monopolist will seek to extract a price from consumers that is above the cost of resources used in making the product. And higher prices mean that consumers’ needs and wants are not being satisfied, as the product is being under-consumed. Under conditions of monopoly, consumer sovereignty has been partially replaced by producer sovereignty.

In the two diagrams above we contrast a market where demand is price inelastic (i.e. Ped <1) with one where demand is more sensitive to price changes (i.e. Ped>1). The former is associated with a monopoly where consumers have few close substitutes to choose from. When demand is inelastic, the level ofconsumer surplus is high, raising the possibility that the monopolist can reduce output and raise price above cost thereby operating with a higher profit margin (measured as the difference between price and average cost per unit).

If a monopoly reduces output from the equilibrium at Q1 to Q2 then it can sell this at a price P2. This results in a transfer of consumer surplus into extra producer surplus. But because price is now about the cost of supplying extra units, there is a loss of allocative efficiency. This is shown in the diagram by the shaded area which is not transferred to the producer, merely lost completely because output is lower than it would otherwise be in a competitive market.

Example: UK Cement Monopoly under Scrutiny
The Competition Commission is investigating the market for aggregates, cement and ready-mix concrete. Five businesses account for 90% of the cement market, 75% of aggregates and 68% of ready-mix concrete. There are worries that a lack of competition has raised building costs, meaning the government is paying too much for schools, hospitals and roads.

Source: News reports, Aug 2011

Example: Sky Film Monopoly criticized

Sky's control over pay-TV movie rights in the UK is restricting competition, leading to higher prices and reduced choice, the UK Competition Commission has ruled. The commission may decide to restrict the number of Hollywood studies from which Sky currently has the exclusive rights to be the first to air their new releases. Sky has twice as many pay-TV subscribers as all its rivals combined - a reflection of its market dominance.

Source: News reports, Aug 2011

Higher costs – loss of productive efficiency:

• Another possible cost of monopoly power is that businesses may allow the lack of real competition to cause a rise in costs and a loss of productive efficiency.
• When competition is tough, businesses must keep firm control of their costs because otherwise, they risk losing market share. 
• Some economists go further and say that monopolists may be even less efficient because, if they believe that they have a protected market, they may be less inclined to spend money on research and improved management.
• These inefficiencies can lead to a waste of scarce resources.

Evaluation – Potential Economic Benefits of Monopoly

The possible benefits of monopoly power suggest that the government and the competition authorities should be careful about intervening directly in markets and try to break up a monopoly. Market power can bring advantages both to the firms themselves and also to consumers and these should be included in any evaluation of a particular market or industry.

1. Research and development spending: Huge corporations enjoying big profits are well placed to fund capital investment and research and development projects. The positive spill-over effects of research can be seen in more innovation. This is particularly the case in industries such as telecommunications and pharmaceuticals. This can lead to gains in dynamic efficiency and social benefits.
2. Exploitation of economies of scale: Because monopoly producers often supply on a large scale, they may achieve economies of scale – leading to a fall in average costs.
3. Monopolies and international competitiveness: The British economy needs multinational companies operating on a scale large enough to compete in global markets. A firm may enjoy domestic monopoly power, but still face competition in overseas markets.

SPEW
Here is a good way to remember some of the issues we have covered regarding monopoly, efficiency and economic welfare

Service - does the lack of competition affect the quality of service to consumers?
Prices - how high are prices compared to competitive / contestable market
Efficiency - productive, allocative and dynamic
Welfare - what are the overall welfare outcomes? Is there a net loss of welfare in markets dominated by businesses with monopoly power?
Acknowledged source: Ruth Tarrant

Government Intervention in Markets – an introduction to UK competition policy

Competition policy involves the regulation of markets to protect and improve consumer welfare:

• The Competition Commission – its main concern is to investigate mergers and takeovers to examine if these mergers will have a negative effect on competition. It also engages in in-depth investigations of markets where there are competition worries. A good example was the recent report into the UK supermarket industry.
• The Office of Fair Trading reports on allegations of anti-competitive practices including claims ofcollusive “price-fixing” behaviour.
• The European Competition Authority examines anti-competitive behaviour, mergers and takeovers between European businesses and investigates state aid to struggling businesses to make sure that subsidies do not reduce or distort competition.
• Utility regulators such as OFGEM, OFCOM and OFWAT monitor the industries that were privatised during the 1980s and 1990s. The regulators have used the power to introduce and review price capping and they have also have sought to bring fresh competition into markets. Competition was introduced into the telecommunications in 1984; in Gas from 1996-98 and in Electricity from 1998.

Many markets have firms with monopoly power but they seem to work perfectly well from the point of view of the consumer. Although there is a consensus among many economists that competition is a force for good in the long-run, we should be careful not simply to assume that monopoly power is bad and competition is good. There are persuasive arguments on both sides.

Competition Policy Snapshots
In the Frame
The European Commission has launched two competition inquiries to study whether IBM has abused its dominant position in mainframe computers. The study will examine whether IBM has put obstacles in place that prevent competitors from operating freely. The other inquiry, launched by the Commission itself, will look at IBM’s relations with maintenance suppliers. (August 2010)
Bathroom cartel
Seventeen bathroom equipment makers have been fined a total of 622m Euros by the European Commission for price-fixing. Given the relatively homogenous nature of the products offering in this industry, and the high concentration ratio, it is ripe for collusion and cartel-like behaviour. (June 2010)
Capping mobile charges
The Telecoms regulator OFCOM has ordered UK mobile phone companies to cut the cost of termination charges - levied when people phone different networks from 4.5p to 0.5p by 2015. Mobile termination rates are the wholesale charges that operators make to connect calls to each others’ networks. (April 2010)
Heavy fines for tobacco cartel
The Office of Fair Trading (OFT) has given out the largest ever total fine in a case under the UK Competition Act 1998. A huge fine has been imposed on two tobacco manufacturers and ten retailers engaged in illegal price fixing for tobacco products in the UK. This is a good example of the financial risks that companies face when found guilty of anti-competitive behaviour. The tobacco manufacturers involved are Imperial Tobacco and Gallaher, and the retailers are Asda, The Co-operative Group, First Quench, Morrisons, One Stop Stores (formerly T&S Stores), Safeway, Sainsbury’s, Shell, Somerfield and TM Retail.
Imperial Tobacco was fined £112m and Co-op and Asda were penalized by £14m each (April 2010)

Source: Tutor2u Economics Blog

CONSUMERS SURPLUS,IGCSE,GCEO NOTES

Consumer surplus

When there is a difference between the price that you pay in the market and the value that you place on the product, then the concept of consumer surplus becomes a useful one to look at.

• Consumer surplus is a measure of the welfare that people gain from consuming goods and services
• Consumer surplus is the difference between the total amount that consumers are willing and able to pay for a good or service (indicated by the demand curve) and the total amount that they actually do pay (i.e. the market price).
• Consumer surplus is shown by the area under the demand curve and above the equilibrium price as in the diagram below.

Consumer surplus and price elasticity of demand

1. When the demand for a good or service is perfectly elastic, consumer surplus is zero because the price that people pay matches what they are willing to pay. 

2. In contrast, when demand is perfectly inelastic, consumer surplus is infinite. Demand does not respond to a price change. Whatever the price, the quantity demanded remains the same. Are there any examples of products that have such zero price elasticity of demand?

3. The majority of demand curves are downward sloping. When demand is inelastic, there is a greater potential consumer surplus because there are some buyers willing to pay a high price to continue consuming the product. This is shown in the next diagram.

• When there is a shift in the demand curve leading to a change in the equilibrium market price and quantity, then the level of consumer surplus will change too
• In the left hand diagram, following an increase in demand from D1 to D2, the equilibrium market price rises to from P1 to P2 and the quantity traded expands. There is a higher level of consumer surplus because more is being bought at a higher price than before.
• In the diagram on the right we see the effects of a cost reducing innovation which causes an outward shift of market supply, a lower price and an increase in the quantity traded in the market. As a result, there is an increase in consumer welfare shown by a rise in consumer surplus.

Consumer surplus can be used frequently when analysing the impact of government intervention in any market – for example the effects of indirect taxation on cigarettes consumers or the introducing of road pricing schemes such as the London congestion charge or a rise in air passenger duty.

Profit notes ,IGCSE,GCEO LEVEL

The Nature of Profit

Profit measures the return to risk when committing scarce resources to a market or industry.

Entrepreneurs organise factors of production and take risks for which they require an adequate rate of return. The higher the market risk and the longer they expect to have to wait to earn a positive return, the greater will be the minimum required return that an entrepreneur is likely to demand.

Economists distinguish between different types of profit:

Normal profit - is the minimum level of profit required to keep factors of production in their current use in the long run.

Normal profits reflect the opportunity cost of using funds to finance a business. If you put £200,000 of savings into a new business, those funds could have earned a low-risk rate of return by being saved in a bank account. You might use the rate of interest on that £200,000 as the minimum rate of return that you need to make from your investment

Because we treat normal profit as an opportunity cost of investing financial capital in a business, we include an estimate for normal profit in the average total cost curve, thus, if the firm covers its AC then it is making normal profits.

Sub-normal profit - profit less than normal (P < average cost)

Abnormal profit - is any profit achieved in excess of normal profit - also known as supernormal profit. When firms are making abnormal profits, there is an incentive for other producers to enter a market to try to acquire some of this profit. Abnormal profit persists in the long run in imperfectly competitive markets such as oligopoly and monopoly where firms can successfully block the entry of new firms. We will come to this later when we consider barriers to entry in monopoly.

Calculating economic profit

Consider the following example:The table shows data for an owner-managed firm for a particular year.

• Total revenue £320,000
• Raw material costs £30,000
• Wages and salaries £85,000
• Interest paid on bank loan £30,000
• Salary that the owner could have earned elsewhere £32,000
• Interest forgone on capital invested in the business £20,000

In a simple accounting sense, the business has total revenue of £320,000 and costs of £145,000 giving an accounting profit of £175,000. But profit according to an economist should take into account the opportunity cost of the capital invested and the income that the owner could have earned elsewhere. Taking these two items into account we find that the economic profit is £123,000.

Accounting Profit and Economic Profit

Short Run Profit Maximisation

Profits are maximised when marginal revenue = marginal cost

Price Per Unit (AR) (£)	Demand / Output (units)	Total Revenue (TR) (£)	Marginal Revenue (MR) (£)	Total Cost (TC) (£)	Marginal Cost (MC) (£)	Profit (£)
50	33	1650		2000		-350
48	39	1872	37	2120	20	-248
46	45	2070	33	2222	17	-152
44	51	2244	29	2312	15	-68
42	57	2394	25	2384	12	10
40	63	2520	21	2444	10	76
38	69	2622	17	2480	6	142
36	75	2700	13	2534	9	166
34	81	2754	9	2612	13	142

Consider the example in the table above. As price per unit declines, so demand expands. Total revenue rises but at a decreasing rate as shown by the column showing marginal revenue. Initially the firm is making a loss because total cost exceeds total revenue. The firm moves into profit at an output level of 57 units. Thereafter profit is increasing because the marginal revenue from selling units is greater than the marginal cost of producing them. Consider the rise in output from 69 to 75 units. The MR is £13 per unit, whereas marginal cost is £9 per unit. Profits increase from £142 to £166.

But once marginal cost is greater than marginal revenue, total profits are falling. Indeed the firm makes a loss if it increases output to 93 units.

As long as marginal revenue > marginal cost, total profits will be increasing (or losses decreasing). The profit maximisation output occurs when marginal revenue = marginal cost.
In the next diagram we introduce average revenue and average cost curves into the diagram so that, having found the profit maximising output (where MR=MC), we can then find (i) the profit maximising price (using the demand curve) and then (ii) the cost per unit.

• The difference between price and average cost marks the profit margin per unit of output.
• Total profit is shown by the shaded area and equals the profit margin multiplied by output

The Short Run Supply Decision - The Shut-down Price

A business needs to make at least normal profit in the long run to justify remaining in an industry but in the short run a firm will continue to produce as long as total revenue covers total variable costs orprice per unit > or equal to average variable cost (AR = AVC). This is called the short-run shutdown price.

The reason for this is as follows. A business’s fixed costs must be paid regardless of the level of output. If we make an assumption that these costs cannot be recovered if the firm shuts down then the loss per unit would be greater if the firm were to shut down, provided variable costs are covered.

• Average revenue (AR) and marginal revenue curves (MR) lies below average cost, so whatever output produced, the business faces making a loss
• At P1 and Q1 (where marginal revenue equals marginal cost), the firm would shut down as price is less than AVC. The loss per unit of producing is vertical distance AC. No contribution is made to fixed costs
• If the firm shuts down production the loss per unit will equal the fixed cost per unit AB.
• In the short-run, provided that the price is greater than or equal to P2, the business can justify continuing to produce
• In the long run the shut down point is AVC=AR because all cost are variable

Recession and factory closures

• The concept of the shutdown point has become topical due to the recession and the weak subsequent recovery
• Many businesses have opted to close down loss-making production plants and retailers have announced the closure of retail outlets in a bid to cut their losses.

Some of the plant closures have been temporary, for example some high-profile car manufacturers mothballed their factories and reduced the number of shifts. But for other businesses, the downturn brought about an end to trading. We have seen the demise of a large number of well-known retail businesses.

Deriving the Firm’s Supply Curve in the Short Run

• In the short run, the supply curve for a business operating in a competitive market is the marginal cost curve above average variable cost.
• In the long run, a firm must make a normal profit, so when price = average cost, this is the break-even point. It will therefore shut down at any price below this in the long run. 
• As a result the long run supply curve will be the marginal cost curve above average total cost.

The concept of a ‘supply curve’ is inappropriate when dealing with monopoly because a monopoly is a price-maker, not a “passive” price-taker, and can thus select the price and output combination on the demand curve so as to maximise profits where marginal revenue = marginal cost.

Changes in demand

• A change in demand and/or production costs will lead to a change in the profit maximising price and output.
• In exams you may often be asked to analyse how changes in demand and costs affect the equilibrium output for a business. Make sure that you are confident in drawing these diagrams and you can produce them quickly and accurately under exam conditions.
• In the diagram below we see the effects of an outward shift of demand from AR1 to AR2 short run costs of production remain unchanged). The increase in demand causes a rise in the price from P1 to P2 (consumers are now willing and able to buy more at a given price) and an expansion of supply (the shift in AR and MR is a signal to firms to move along their marginal cost curve and raise output). Total profits have increased.

Functions of Profit in a Market Economy 

Milk farmers could lose thousands of pounds a year after suppliers imposed a huge cut in milk prices. The average cow produces 7,500 liters of milk a year, meaning an annual loss of £45,000 for a typical herd of 120 cows. The number of dairy farmers has halved in the past ten years.
Robert Wiseman Dairies, Arla Foods UK and Dairy Crest – intend to cut the prices paid to farmers for milk. The processors say the move is a result of deterioration in the commodity markets for skimmed milk powder and wholesale cream. Some of the major retailers have corporate responsibility strategies which include terms to protect farmers. Tesco and Sainsbury's pay a price per liter that covers the cost of production, with Sainsbury's paying 30.56p per liter. Waitrose pays a market leading price, aiming to top the prices paid by the other retailers

Profits serve a variety of purposes in a market economy:

1. Finance for investment Retained profits are source of finance for companies undertaking investment. The alternatives such as issuing new shares (equity) or bonds may not be attractive depending on the state of the financial markets especially in the aftermath of the credit crunch.
2. Market entry: Rising profits send signals to other producers within a market. When existing firms are earning supernormal profits, this signals that profitable entry may be possible. In contestable markets, we would see a rise in market supply and lower prices. But in a monopoly, the dominant firm(s) can protect their position through barriers to entry.
3. Demand for factor resources: Scarce factor resources flow where the expected rate of return or profit is highest. In an industry where demand is strong more land, labour and capital are then committed to that sector.
4. Signals about the health of the economy: The profits made by businesses throughout the economy provide important signals about the health of the macro economy. Rising profits might reflect improvements in supply-side performance (e.g. higher productivity or lower costs through innovation). Strong profits are also the result of high levels of demand from domestic and overseas markets. In contrast, a string of profit warnings from businesses could be a lead indicator of a macroeconomic downturn.

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