Microeconomic and Organisational

Context: The Market System

Different market systems:

Given that resources are limited (‘scarce’), it is not possible to make everything
everyone would want (‘unlimited wants’). All societies are thus faced with a
fundamental economic problem:

a) What goods and services should be produced?

b) In what quantities?
c) Who should make them?
d) Who gets the output?

There are three main economic systems or approaches to solve this problem:

a) A market economy – interaction between supply and demand (market

forces) determines what is made, in what quantity and who gets the
output. Patterns of economic activity are determined by the decisions
made by individual consumers and producers.

b) A command economy – production decisions are controlled by the

government.

c) A mixed economy – in reality most modern economies are a mix of free

markets and government intervention.

Market forces:

In a free market, the quantity and price of goods supplied in a market are
determined by the interaction between supply and demand.
A market price will be set by the 'invisible hand of the market' through the
interaction of supply and demand.

Demand:

Individual demand:

Individual demand shows how much of a good or service someone intends to

buy at different prices.

This demand needs to be effective in that it is backed by available money,

rather than just a general desire without the necessary financial backing.

When considering demand at a price, we assume that the conditions of

demand (i.e. other variables – see below) are held constant.

For most goods, the lower the price, the higher will be its demand.
When the demand for a good or service changes in response to a change in its
price, the change is referred to as:
a) – an expansion in demand where quantity demanded rises due to a fall
in price.
b) – a contraction in demand where quantity demanded falls due to a rise
in price.

The relationship between demand and price can be shown in a diagram and is
referred to as a demand curve.

(Note: For such graphs we plot quantity along the horizontal axis and price
on the vertical axis. This may seem the wrong way round to you as we are
arguing here that demand depends on price and we normally have the
dependent variable on the vertical axis. However, this is the accepted
approach for economics.)

Thus, in the diagram below, the downward-sloping demand curve D illustrates

the demand for a normal good. Movements along this curve as the price
changes would be called a contraction in demand (price is rising) or an
expansion in demand (price is falling).
Market demand:

Market demand shows the total amount of effective demand from all the
consumers in a market. It is an aggregate, like the supply curve for an industry.

Market demand is usually shortened to demand and represented by a straight-

line curve on a graph. The demand curve for most normal goods is negatively
inclined sloping downwards from left to right for reasons explained in the
previous section.

Conditions of demand:

So far, we have considered exclusively the influence of price on the quantity

demanded, assuming other factors to be constant. These factors, termed the
conditions of demand, will now be considered, with the price held constant.

Any change in one or more of the conditions of demand will create shifts in the
demand curve itself.

a) If the shift in the demand curve is outward, to the right, such a shift is
called an increase/rise in demand.

b) If the shift in the demand curve is inward, to the left, such a shift is
called a decrease/fall in demand.

It is important to distinguish such increases and decreases in demand that

result from a shift in the demand curve as a whole from expansions and
contractions in demand that result from price changes leading to movements
along the demand curve itself.
The main conditions of demand are as follows:

a) Income: Changes in income often affect demand. For example, lower

direct taxes would raise disposable incomes and, other things being
equal, make consumers better off and so they spend more on holidays.
For normal goods an increase in income leads to an increase in demand.
Examples could include cars, jewellery, fashion clothing and music
streaming services.

For inferior goods, however, a rise in income leads to a lower demand

for the product as consumers, now being richer, substitute better quality
and preferred goods and services for the original (‘inferior’) good or
service. An example of this is public transport. Here, as incomes rise, the
demand for public transport falls as consumers substitute private
transport such as cars.

b) Tastes: Tastes, in particular fashions, change frequently and it may make

the demand for certain goods volatile.

A good example of this was the rapid rise in demand for fidget spinners
seen in 2017 followed by a decline as people’s attention moved
elsewhere. Tastes, of course, can be manipulated by advertising and
producers to try to ‘create’ markets, particularly for ostentatious goods,
for example, air conditioners which our ancestors survived perfectly well
without. Some goods are in seasonal demand (e.g. cooked meat) even
though they are available all year round, because tastes change (i.e.
more salads are consumed in the summer).

c) The prices of other goods: Goods may be unrelated, or they may be

complements or substitutes. The former has no effect but the latter two
are significant. If goods are in joint demand (i.e. complements such as
cars and tyres) a change in the price of one will affect the other also.
Therefore, if the price of cars falls, there is likely to be an increase in
demand for tyres. Where goods are substitutes (e.g. Coke and Pepsi, or
McDonald's and Burger King), a rise in the price of one will cause an
increase in demand for the other (and thus the demand curve for the
other will shift to the right).
 Sometimes, technological breakthroughs mean that new products come
into the market. For instance, the introduction of affordable streaming
services for music and films has reduced the demand for CDs and DVDs
(the latter leading to the closure of the Blockbuster chain).

d) Population: An increase in population creates a larger market for most

goods, thereby shifting demand outwards. For instance, an influx of
immigrant workers will raise the demand for most essential goods.
Changes in population distribution will also affect demand patterns. If
the proportion of old people relative to young people increases, then
the demand for products such as false teeth, wheelchairs and old
people’s homes will increase to the detriment of gripe water, nappies
and cots.

In the analysis of how the demand and supply model works, the
distinctions between increase/decrease in demand and
expansion/contraction in demand are very important.

Remember:

1. If a price change occurs, there will be a movement along the demand

curve and the result will be either an expansion or a contraction in
demand

2. If the conditions of demand change, there will be a shift in the demand

curve and the result will be either an increase or a decrease in demand.
Elasticity of demand:

Elasticity, generally, refers to the relationship between two variables and

measures the responsiveness of one (dependent) variable to a change in
another (independent) variable: There are several types which are useful to
economists. Management accountants are particularly interested in knowing
price elasticity of demand as this can give a good indication of the optimal
price for a good or service.

Price elasticity of demand (PED):

This concept explains the relationship between changes in quantity demanded

and changes in price.

a) Price elasticity of demand explains the responsiveness of demand to

changes in price.

b) The co-efficient of price elasticity of demand (PED) is calculated by:

Percentage change in quantity demand/Percentage change in price

The formula can be applied either at one point on the demand curve or over
part (arc) of it. It is critical that percentage or proportional changes are used
rather than absolute ones.

Definitions:

There are two ways of calculating PED using the 'arc method'. Both of these
methods are examinable.

1. non-average arc method – measures % change in price / % change in

quantity using the starting point of price and quantity as the basis for
the % calculation.

2. average arc method – measures % change in price / % change in

quantity using the average price and quantity as the basis for the %
calculation.
The 'Point method' is an alternative that requires use of calculus and will not
be taught or tested at this level.

D1 shows unit elasticity (% change in demand = % change in price).

D2 shows inelastic demand (% change in demand smaller than % change in

price).

D3 shows elastic demand (% change in demand larger than % change in

price).

Note that the value of price elasticity of demand will change as you move along
the length of the straight demand curve.

A normal demand curve will always slope downwards from left to right
indicating that a price rise will lead to a contraction in demand and a price fall
will lead to an expansion in demand
Factors that influence PED:

There are several factors which determine the price elasticity of demand:

a) Proportion of income spent on the good: Where a good constitutes a

small proportion of consumers’ income spent, then a small price change
will be unlikely to have much impact. Therefore, the demand for
unimportant items such as shoe polish, matches and pencils is likely to
be very inelastic. Conversely, the demand for quality clothing will
probably be elastic.

b) Substitutes: If there are close and available substitutes for a product,

then an increase in its price is likely to cause a much greater fall in the
quantity demanded as consumers buy suitable alternatives. Thus, the
demand for a specific variety box of chocolates may be fairly elastic
because there are many competing brands in the market. In contrast,
the demand for a unique product such as the Time form Racehorses
Annual for racing enthusiasts will tend to be inelastic.

c) Necessities: The demand for vital goods such as sugar, milk and bread
tend to be stable and inelastic; conversely luxury items such as foreign
skiing holidays are likely to be fairly elastic in demand. It is interesting to
note that improvements in living standards push certain commodities
such as televisions from the luxury to the necessity category.

d) Habit: When goods are purchased automatically, without customers

perhaps being fully aware of their price, for example, newspapers, the
demand is inelastic. This also applies to addictive products such as
cigarettes, cocaine and heroin.

e) Time: In the short run, consumers may be ignorant of possible

alternative goods in many markets, so they may continue to buy certain
goods when their prices rise. Such inelasticity may be lessened in the
long run as consumers acquire greater knowledge of markets and
substitute goods.

f) Definition of market: If a market is defined widely (e.g. food), there are

likely to be fewer alternatives and so demand will tend to be inelastic. In
contrast, if a market is specified narrowly (e.g. orange drinks) there will
 probably be many brands available, thereby creating elasticity in the
demand for these brands.

The link between PED and total revenue:

The PED can also be calculated by examining total revenue. This method is
most useful to business people.

a) If total revenue increases following a price cut, then demand is price

elastic.

b) If total revenue increases following a price rise, then demand is price

inelastic.

Conversely, if total revenue falls after a price cut, then the demand is inelastic;
and after a price rise it is elastic. If total revenue remains unchanged, then the
demand is of unitary elasticity.
Supply:

The supply curve of a firm:

A supply curve shows how much producers would be willing and able to offer
for sale, at different prices, over a given period of time.

The supply curve of a firm is underpinned by the desire to make profit. It

demonstrates what a firm will provide to the market at certain prices. Given
that cost is one of the main determinants of supply an increase in price will
usually result in greater supply. Thus, supply curves are usually upward sloping.
Decrease in supply:

At existing prices less will now be supplied, as shown on the upward-sloping,

elastic supply curve. At price P, the quantity supplied falls from Q to Q1 as the
supply curve shifts from S2 to S1. This means that the cost of supply has
increased.

This results from:

a) Higher production costs. The costs of production may increase because

the factors of production (land, labour, capital and enterprise) become
expensive. Thus conditions such as higher wage costs per unit, higher
input prices and increased interest rates will lead to reductions in
supply.

b) Indirect taxes. The imposition of an indirect tax makes supply at existing

prices less profitable. With an indirect tax the costs of production are
raised directly because the tax must be paid on each good sold
irrespective of how much of the tax can be recouped via a higher price.
The profit margin is reduced (by some varying amount) as an indirect
effect.

An increase in supply:

For example, a shift in the supply curve from S1 to S2 illustrates an increase in

supply with more being supplied at each price, showing that the cost of
production has fallen or lower profits are being taken.

Lower unit costs may arise from:

a) technological innovations, for example, the advance of microchip

technology lowered the cost of computers and led to large increases in
supply

b) more efficient use of existing factors of production, for example,

introduction of a shift system of working might mean fuller use of
productive capacity, leading to lower unit costs. Improvements in
productivity may be secured by maintaining output but with fewer
workers
 c) lower input prices, such as cheaper raw material imports and lower-
priced components could bring down production costs

d) a reduction or abolition of an indirect tax or the application of or

increase in subsidies.

Factors of production:

Economic resources are referred to as factors of production. These are usually

classified as:

a) Land: This is the term used to cover all-natural resources. Although

largely limited in supply it can be improved through technological
advances, for example irrigation

b) Labour: This is a specific category of human resource. The quality of

labour can be raised through education and training. The application of
capital, through the use of machinery, will improve labour productivity.

c) Enterprise: This is another human resource but refers to the role played
by the organiser of production, including risk-taking, organising and
decision making.

d) Capital: These are man-made resources. Capital may be fixed, for

example a factory, or not, for example working capital in the form of raw
materials and work-in-progress.
A normal supply curve will always slope upwards from left to right indicating
that suppliers are willing to supply more the higher is the price. Thus, a price
rise will lead to an expansion in supply and a price fall will lead to a contraction
in supply.

Therefore, the value of the price elasticity of supply (PES) is always positive.

a) If a change in price induces a larger proportionate change in the quantity

supplied, the price elasticity of supply will have a value of more than 1
and supply is said to be price elastic.

b) If a change in price induces a smaller proportionate change in the

quantity supplied, the price elasticity of supply will have a value of less
than 1 and supply is said to be price inelastic. The extreme case would
be perfectly inelastic where supply is completely unaffected by price.
 c) If a change in price induces an equally proportionate change in the
quantity supplied, the price elasticity of supply will have a value of 1 and
supply is said to have unit elasticity.

Factors that influence elasticity of supply:

There are several factors which affect the elasticity of supply:

a) Time. Supply tends to be more elastic in the long run. Production plans
can be varied and firms can react to price changes. In some industries,
notably agriculture, supply is fixed in the short run and thus perfectly
inelastic. However, in manufacturing, supply is more adaptable.

b) Factors of production. Supply can be quickly changed (elastic) if there

are available factors, such as trained labour, unused productive capacity
and plentiful raw materials, with which output can be raised. Although
one firm may be able to expand production in the short run, a whole
industry may not, so there could be a divergence between a firm’s
elasticity and that of the industry as a whole.
 c) Stock levels. If there are extensive stocks of finished products
warehoused, then these can be released onto the market, making supply
relatively elastic. Stock levels tend to be higher when business people
are optimistic and interest rates are low.

d) Number of firms in the industry. Supply will tend to be more elastic if

there are many firms in the industry, because there is a greater chance
of some having the available factors and high stock. Also, it is possible
that industries with no entry barriers or import restrictions could expand
supply quickly as new firms enter the industry in response to higher
prices

The price mechanism:

Equilibrium:

Now we have looked at demand and supply in detail, let us consider how the
price mechanism sets a price.

The way to see how market forces achieve equilibrium is to consider what
happens if the price is too high or too low:
The graph shows the intended demand and planned supply at a set of prices. It
is only at price P where demand and supply are the same. If the demand of
consumers and the supply plans of sellers correspond, then the market is
deemed to be in equilibrium.

Only at output Q and price P are the plans of both sellers and buyers realised.
Thus, Q is the equilibrium quantity and P is the equilibrium price in this
market.

There is only one equilibrium position in a market. At this point, there is no

tendency for change in the market, because the plans of both buyers and
sellers are satisfied. At prices and outputs other than the equilibrium (P, Q)
either demand or supply aspirations could be fulfilled but not both
simultaneously.

For instance, at price P1, consumers only want Q1 output but producers are
making Q2 output available. There is a surplus of supply, the excess supply
being the difference between the Q1 and Q2 output levels.

Assuming the conditions of demand and supply remain unchanged, it is likely

that the buyers and sellers will reassess their intentions.

This will be reflected in the short term by retailers having unwanted goods,
returns made to manufacturers, reduced orders and some products being
thrown away and so suppliers may be prepared to accept lower prices than P1
for their goods.

This reduction in price will lead to a contraction in supply and an expansion in

demand until equilibrium is reached at price P.

Conversely, at a price of P2, the quantity demanded, Q2, will exceed the
quantity supplied, Q3. There will be a shortage of supply (Q2 – Q3),
demonstrating the excess demand.

This will be reflected in the short term by retailers having empty shelves,
queues and increased orders. Furthermore, there may be high second-hand
values, for example on eBay. The supplier will respond by increasing
prices to reduce the shortage.
This excess demand will thus lead to a rise in the market price, and demand
will contract and supply will expand until equilibrium is reached at price P.

A supply and demand analysis can be applied to many different markets:

a) Supply of and demand for money gives an equilibrium price that can be
interpreted as the level of interest rates in an economy.

b) Supply of and demand for a particular currency gives an equilibrium

price in the form of an exchange rate.

Shifts in supply and or demand:

As well as signalling information in a market, price acts as a stimulant. The

price information may provide incentives for buyers and sellers. For instance, a
price rise may encourage firms to shift resources into one industry in order to
obtain a better reward for their use.
For example, suppose the equilibrium is disturbed when the conditions of
demand change. Consumers’ tastes have moved positively in favour of the
good and a new curve D1 shows customers’ intentions.

Supply is initially Q, at the equilibrium, and it is momentarily fixed, so the

market price is bid up to P1.

However, producers will respond to this stimulus by expanding the quantity

supplied, perhaps by running down their stocks.

This expansion in supply to Q2 reduces some of the shortage, bringing

price down to P2, a new equilibrium position, which is above the old
equilibrium P.

Note that if we had drawn the diagram with steeper supply (and demand
curves), then the price fluctuations would have been greater. Thus the more
inelastic the demand and supply of a good are, the greater will be price
volatility when either demand or supply shifts.

The longer-term effects of these changes in the market depend upon the
reactions of the consumers and producers. The consumers may adjust their
preferences and producers may reconsider their production plans. The impact
of the latter on supply depends upon the length of the production period.

Generally, the longer the production period, and the more inelastic the supply
is, the more unstable price will tend to be.

a) Price acts as a signal to sellers on what to produce.

b) Price rises, with all other market conditions unchanged, will act as a
stimulus to extra supply.
c) Equilibrium price is where the plans of both buyers and sellers are
satisfied.
Market failure:

Introduction:

In theory market forces should result in allocation of resources in a way that

maximises the utility (benefits) for consumers. However, in some
circumstances, markets can lead to sub-optimal allocation of resources,
leading to under- or over-production of certain goods and services.

This inability of a market to allocate resources in a way that maximises utility is

called market failure.

Government can then have a role to intervene to ensure that a market

function efficiently.

Public goods:

Without government intervention some goods would not be provided at all by

a market economy. These are often referred to as public goods.

Public goods have the following properties:

a) non-excludability – a person can benefit from the good without having

to pay for it (the "free rider" concept). Provision of the good for one
member of society automatically allows the rest of society also to
benefit.

b) non-rivalry – consumption of the good by one person does not reduce

the amount available for consumption by others.

As a result, a market for this type of goods does not exist and so must be
provided by the state.
Externalities:

Externalities are social costs or benefits that are not automatically included in
the supply and demand curves for a product or service. Social costs arising
from production and consumption of a good or service are described as
negative externalities and social benefits as positive externalities.

Supply and demand curves only take into account private costs and benefits,
i.e. the costs that accrue directly to the supplier or the benefits that accrue
directly to the consumer.

Externalities:

An externality occurs when the costs or benefits of an economic action are not
borne or received by the instigator. Externalities are, therefore, the spill-over
effects of production and consumption which affect society as a whole rather
than just the individual producers or consumers.

a) Externalities created by nationalised industries can be good and bad.

For example, the railways may be beneficial by relieving roads of
congestion and maintaining communications for isolated communities,
but may be detrimental in terms of noise and air pollution.

b) The pricing policies considered so far have been based purely on

private costs. If any pricing policy was to maximise net social benefit (or
minimise net social cost) then costs would need to include such
externalities.

c) Calculate social costs. These would indicate the true cost to society of
production to incorporate into decision making. However, externalities
are very difficult to calculate as they are not always attributable, for
example noise, and their impact is not universally identical.

d) Use indirect taxes and subsidies. Where private costs of production or

consumption are below social costs, an indirect tax could be imposed so
that price is raised to reflect the true social costs of production. Taxes on
alcohol and tobacco can be justified on these grounds. Subsidies to
home owners to install roof insulation will reduce energy consumption
and help conserve a scarce resource for wider social benefit.
 e) Extend private property rights so that firms are still liable for the
outputs of their activities even after their product/service has been
sold. This is reflected in the way many firms are subjected to compulsory
recycling programmes e.g. various waste electronics and waste
packaging initiatives, end of lifecycle vehicle directives and so on, as well
as noise emission taxes.

f) Regulations. A government can set maximum permitted levels of

emission or minimum levels of environmental quality. The European
Union has over 200 pieces of legislation covering environmental
controls. Fines can be imposed on firms contravening these limits.

g) Tradable permits. A maximum permitted level of emission is set for a

given pollutant, for example carbon emissions, and a firm or a country is
given a permit to emit up to this amount. If it emits less than this
amount, it is given a credit for the difference, which it can sell to enable
the buyer to go above its permitted level. Thus the overall level of
emissions is set by a government or regulatory body, whereas their
distribution is determined by the market.

Despite the many measures to deal with externalities, the issue of achieving
the socially optimal level of production remains unresolved.

Problems of calculating externalities and the correct level of taxation; issues of

avoidance and enforcement; administrative costs can all mean that market
failure and how to deal with it has yet to find an optimum solution.

Merit goods:

One way of looking at merit goods is in terms of externalities. Merit goods are
characterised by external social benefits (i.e. positive externalities) in
consumption or by lack of knowledge of the private benefits in consumption.
This would lead to under consumption of such services and health and
education.

Moreover, merit goods are also ones that it is generally agreed should be
available to all, irrespective of the ability to pay. Thus, governments often
provide health and education services even though, unlike public goods, these
can be provided by the market.
Thus, merit goods may be underprovided by the market because of

a) ignorance of consumers of the private benefits

b) failure of the market to reflect the social benefits
c) excessive prices limiting access to these services.

Note: some consumers possess the means and the willingness to buy merit
goods, such as education and healthcare

Furthermore, the private sector often provides alternatives, although these are
often seen as ‘different’, or even superior goods/services, for example, private
school education, private health schemes. In the case of state-provided merit
goods, economies of scale can often be achieved, so the cost of education per
student is about three times cheaper in the state sector than in the private
sector, for example.

Demerit goods:

A demerit good is a good or service which is considered unhealthy, degrading,

or otherwise socially undesirable due to the perceived negative effects on the
consumers themselves. The concern is that a free market results in excessive
consumption of the goods.

Examples include smoking (tobacco), excessive consumption of alcohol,

recreational drugs, gambling and junk food.

While some would argue that the consumption of reasonable amounts of

alcohol is acceptable and should not be legislated against by a "nanny state",
they would also agree that excessive binge drinking causes significant
problems both for the user and others. (Note: with demerit goods we are
particularly looking at the effect on the user in contrast with negative
externalities where we considered the impact on society as a whole).

Government responses usually involve regulating or banning consumption,

banning advertising of these goods and the use of higher taxes (sometimes
known as "sin taxes").
Competition policy:

As markets have become more heavily concentrated among fewer firms more
controls have been applied to restrictive trade practices and pricing. The
economic justifications for such a policy are fairly clear.

a) Collusion by suppliers and the operation of cartels usually lead to higher

prices and/or monopoly profits and possibly lower output.

b) These in turn reduce consumer welfare.

c) Furthermore, they are a diminution in allocative efficiency. However, it

must be remembered that extra profits may lead to investment in
research, which could eventually benefit consumers via new products.

Scope of regulation:

There are three aspects to this which involve government regulation:

a) Mergers and acquisitions:

Many countries have bodies that monitor and assess mergers and
acquisitions to see if the resulting organisation has excessive market
power that is deemed to be against the public interest.

In the UK this role is taken by the Competition and Markets Authority

(formerly the Competition Commission) and a 25% market share or
above is seen as a possible indicator of a "substantial lessening of
competition" that may warrant further investigation.

b) Restrictive trade practices:

Activities such as collusion over price fixing reduce competition within a
market and undermine consumer sovereignty.

In the UK, the Competition and Markets Authority (CMA) investigates

anti-competitive behaviour in markets. In the USA, the Federal Trade
Commission protects consumers and maintains competition.
 c) State created regional monopolies:
Many countries have gone through a process of privatisation thus
converting state owned organisations into private companies. In many
cases these result in regional monopolies, for example with water and
other utilities.

To control such monopolies government set up industry regulators,

such as OFWAT, which regulates water and sewerage providers in
England and Wales. Regulators will negotiate with firms over key
issues of pricing and required investment to leave an appropriate level
of return for shareholders, for example, a maximum ROCE.

Interference with market prices:

There may be occasions when the equilibrium price established by the market
forces of demand and supply may not be the most desirable price. With such
cases the government might wish to set prices above or below the market
equilibrium price.

Minimum price:

In certain markets government may seek to ensure a minimum price for

different goods and services. It can do this in a number of ways such as
providing subsidies direct to producers (e.g. the Common Agricultural Policy).

Alternatively, it can set a legal minimum price (e.g. a statutory minimum

wage).

To be effective legal minimum prices must be above the current market price.
If the government sets a minimum price above the equilibrium price (often
called a price floor), there will be a surplus of supply created.
In the diagram this surplus is the difference between Q2 and Q1.

If this minimum price was applied in the labour market it would be known as a
minimum wage and the surplus would be the equivalent of unemployment,
which would be a waste of a factor of production.

If applied to physical goods, then price floors cause surpluses of products

which have to be stored or destroyed. With the EU Common Agricultural Policy
(CAP) this, for many years, resulted in the EU storing large quantities of food
("butter mountains"), selling the surplus to countries outside the EU (such as
Russia) and even paying farmers not to grow the product in the first place but
to remove land from agricultural use (so called "set aside" conditions). These
have now largely disappeared as a result of the reform of CAP (driven in part
by the surpluses).

Many argue, however, that CAP has given farmers stability.

For example, direct payments provide farmers with a steady income and
reward. Left to the mercy of the market, they would be unlikely to be able to
invest in improvements to productivity, food safety or environmental
protection. CAP ensures that Europeans have stable food supplies at
reasonable prices. Increasingly, CAP is used to protect the rural environment.
Farmers get more if they sign up to agro-environmental commitments – using
fewer chemicals, leaving boundaries uncultivated, maintaining ponds, trees,
hedges and protecting wildlife.

Another way of looking at the same problem is to state that it leads to a

misallocation of resources both in the product and/or the factor market which
causes lower economic growth. There also may be the temptation for firms to
attempt to ignore the price floor, for example, by informal arrangements with
workers, which would lead to a further waste of resources in implementing
such arrangements as well as raising issues of fair treatment for the workers
involved.

In summary government-imposed minimum prices cause:

a) Excess supply
b) Misallocation of resources
c) Waste of resources. Note: Alternative approaches to protect farmers
include
d) the use of deficiency payments, where farmers are paid the difference
between a legislatively set target price and the lower national average
market price during a specified time
e) payments of subsidies to farmers, effectively reducing their costs.

Maximum price:

Governments may seek to impose maximum price controls or price ceilings on

certain goods or services, either to:

a) benefit consumers on low incomes, so that they can afford the

particular good, or to
b) control inflation.

To be effective, a legal maximum price must be set below the equilibrium

price.

The effect will be to create a shortage of supply.

This shortage is the difference between Q2 and Q1. If the shortages of supply
persist then problems can arise. The limited supply has to be allocated by some
means other than by price.

This can be done by queuing, by rationing or by some form of favouritism, for

example, by giving preference to regular customers. The difficulty with any of
these alternative mechanisms are that they can be considered arbitrary and
unfair by those who fail to secure the product.

A consequence of the shortage can be the emergence of black markets. This is

where buyers and sellers agree upon an illegal price which is higher than that
which has been officially sanctioned as the maximum price.

Maximum prices can also lead to a misallocation of resources. Producers will

reduce output of those products subject to price controls as these products are
now relatively less profitable than those products where no price controls
exist.

In the housing market this may lead to fewer apartments for rent as
landowners develop office blocks rather than residential houses.

Alternatively, the quality of the product may be allowed to drop as a way of

reducing costs when profits are constrained by price controls. This failure to
maintain property can mean that apartments fall into disrepair.
Economies of scale:

Economies of scale (also known as increasing returns to scale) are defined as

reductions in unit average costs caused by increasing the scale of production in
the long run.

For example, a larger firm may be able to gain greater discounts when
purchasing raw materials.

Diseconomies of scale (also known as decreasing/diminishing returns to scale)

are defined as increases in unit average costs caused by increasing the scale of
production in the long run.

Diseconomies can arise as a firm grows very large. These often reflect the
difficulty of communicating within a large organisation, together with a decline
in management control

Economies and diseconomies of scale:

Managers need to understand whether economies of scale exist or are

possible in their industry and the extent and nature of such economies.

If such economies exist, then firms will need to achieve 'critical mass' in order
to be competitive on cost. The low costs that result allow the firm to set its
prices below those of smaller competitors and can act as a serious barrier to
new firms trying to enter the industry.

Obtaining such scale of production can result from organic growth and/or
acquisition. While this results in larger firms, it often means fewer firms in the
market as well.

This explains why many industries are dominated by large players.

However, the firm should not simply grow for growth’s sake as diseconomies
of scale will erode its cost advantage.
The existence of significant economies of scale can be expected to lead to:

a) costs and therefore prices falling as firms increase their scale of output
b) barriers to entry for newer smaller firms; and
c) industries dominated by a small number of large firms.

Internal economies of scale:

When the advantages of expanding the scale of operation accrue to just one
firm, these economies are termed internal. They can be obtained in one plant,
belonging to a firm, or across the whole company. The main internal
economies are as follows:

a) Technical economies. These relate to the scale of the production and

are usually obtained in one plant. Large-scale operations may make
greater use of advanced machinery. Some machines are only worth
using beyond a minimum level of output which may be beyond the
capacity of a small firm, for example, robots used in car assembly. Such
equipment may facilitate the division of labour. In addition, more
resources can be devoted to research in large firms, because the cost is
borne over more units of output, and this may lead to further technical
improvements and subsequent cost reductions for the whole company.

b) Financial economies. It is usually easier for large firms with household

names to borrow money from commercial banks and raise funds on the
Stock Exchange. Similarly, their loans and overdrafts will probably be
charged at lower interest rates because of their reputation and assets.

c) Trading economies. Large firms may be able to secure advantages both

when buying inputs and selling their outputs. They could employ
specialist buyers and, through the quantity of their purchases, gain
significant discounts from their suppliers.

d) Managerial economies. These are the many administrative gains which

can be achieved when the scale of production grows. The need for
management and supervision does not increase at the same rate as
output. Specialists can be employed and their talents can be fully utilised
in personnel, production, selling, accountancy and so on. Such
organisational benefits may lower the indirect costs of production and
lead to the efficient use of labour resources.
External economies of scale:

It is possible for general advantages to be obtained by all of the firms in an

industry, and these are classed as external economies of scale. Most of these
occur when an industry is heavily concentrated in one area. The area may
develop a reputation for success, for example, computers and electronics in
Silicon Valley in California.

There may be a pool of skilled labour which is available, and this may lower
training costs for a firm. Specialised training may be provided locally in
accordance with the industry’s needs. This might be provided by a training
board to which firms contribute to gain access to the available expertise.

Furthermore, a localised industry may attract to it specialist suppliers of raw

materials, components and services, who gain from a large market and achieve
their own economies of scale, which are passed on through lower input prices.
Occasionally, firms in an industry share their research and development
facilities, because each firm individually could not bear the overheads involved
but can fund a joint enterprise.

Diseconomies of scale:

These exist when the average cost rises with increased production. If they are
specific to one firm they are categorised as internal.

a) Technical diseconomies. The optimum technical size of plant may create

large administrative overheads in its operation, thereby raising average
total costs, even though the production cost is lowered.

b) Trading diseconomies. With large-scale production, products may

become standardised. This lack of individualism may reduce consumer
choice and lead to lower sales. In addition, it may be difficult to quickly
adapt mass-produced goods to changing market trends.

c) Managerial diseconomies. As the chain of command becomes longer in

an expanding hierarchy (when productive capacity grows), senior
management may become too remote and lose control. This may lead to
cross-inefficiency (complacency) in middle management and shop floor
hostility. A concomitant of this is the generally poor state of labour
relations in large organisations, which are more prone to industrial
 stoppages than small firms. This is partly because the trade unions are
better organised. Other administrative weaknesses faced by increasingly
large organisations are the prevalence of red tape and the conflict
between departmental managers who have different objectives and
priorities.

However, there may also be general disadvantages which afflict all firms as
the scale of the industry grows.

The main external diseconomy is technical. If a resource is over utilised then

shortages may arise.

A shortage of labour might lead to higher wages in order to attract new

recruits, while a shortage of raw materials might lower output. Both changes
would raise the average cost of production.