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CHAPTER CONTENTS
LEARNING OUTCOMES -------------------------------------------------- 84
BUSINESS INTEGRATION ----------------------------------------------- 85
MEASURES OF MARKET CONCENTRATION ---------------------------- 86
MONOPOLIES, COLLUSION AND COMPETITION POLICY ------------ 88
MONOPOLIES AND COLLUSION ---------------------------------------- 88
EXTERNALITIES ---------------------------------------------------------- 91
GOVERNMENT INTERVENTION ----------------------------------------- 93
INDIRECT TAXATION AND SUBSISIDIES ----------------------------- 95
GOVERNMENT REGULATION -------------------------------------------- 97
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LEARNING OUTCOMES
(a) Explain market concentration and the factors giving rise to differing levels of
concentration between markets, including acquisitions and combinations.
(b) Identify the impacts of the different forms of competition on prices, output
and profitability.
(c) Explain the main policies to prevent abuses of monopoly power by firms.
(d) Explain market failures and their effects on prices, efficiency of market
operation and economic welfare.
(e) Explain the likely responses of government to market failures.
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BUSINESS INTEGRATION
Ansoff Growth Matrix
The four quadrants represent the potential directions of growth for a firm.
Forms of Growth
The above strategies may be achieved through either organic growth or merger &
acquisition. The below diagram illustrates the growth options available to a miller
(producer of flour used for making bread)
BAKERY
MILL MILL DELICATESSEN
FARMER
a) Forward vertical integration;
b) Horizontal integration;
c) Backward vertical integration;
d) Conglomerate diversification.
Market Penetration
Product Development
Market Development
Diversification
Current New
Current
New
PRODUCTS
MARKETS
(a)
(c)
(d) (b)
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MEASURES OF MARKET CONCENTRATION
The relevance of market concentration enables a greater understanding of the
determinants of price.
As market concentration increases, this limits the availability of substitutes and
therefore reduces price elasticity of demand.
With an inelastic demand curve firms look to increase prices in the knowledge
that the overall reduction in demand will be less than in proportion to the increase
in price, resulting in increased profits!
Measuring market concentration
There are three methods available to measure market concentration:
1. Market concentration ratio (may need to calculate in the exam);
2. Herfindahl index (may need to calculate in the exam);
3. Gini-coefficient.
1. Market concentration ratio A simple percentage of overall output in a
given industry, is calculated for the top four or five firms typically.
2. Herfindahl index The Herfindahl index provides a more accurate
representation of market concentration than that of the market
concentration ratio.
Rather than considering the top four/five firms in an industry, all firms are
included. However, in order to emphasise differentials, the market percentage
share of each firm is squared and then an overall market total calculated!
EXERCISE 1
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The following table shows two markets, each with six firms operating. The
respective market shares are shown in descending order.
Firms Market A %
share
Market B %
share
Market B
1 40 60
2 20 10
3 20 10
4 10 10
5 5 5
6 5 5
Total -
Complete the above table calculating market concentration based on a four
firm ratio, and based on the Herfindahl index?
3. Gini co-efficient and Lorenz Curve
The Gini-coefficient simply measures the deviation of the Lorenz curve from the 45
degree line. The ratio being area A / (A + B).
The output will vary between 0 (perfect competition) and 10,000 (pure monopoly).
Cumulative % of
turnover
Cumulative % of firms
Perfect competition
Lorenz Curve A
B
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MONOLPOLIES, COLLUSION AND COMPETITION POLICY
Market structure spectrum -
Monopoly
A monopoly exists when there is a sole supplier within a given industry. For a
monopoly to exist there must be no close substitutes along with barriers to entering
the market.
As a consequence of there being no close substitutes, demand tends to be relatively
inelastic. The monopolist faces the entire market demand curve, in the absence of
regulation, will produce a level of output that maximizes profits.
Illustration
Barriers to entry
$
Quantity
D0
Competitive
supply
Monopolistic supply
P1
P2
Q2 Q1 Z
Profits gained
Profits lost
Monopoly Duopoly Oligopoly Monopolistic Perfect competition
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1. Product differentiation
2. Exclusive control
3. Economies of scale
4. High start-up costs
5. Cartel agreements
6. Geographical barriers
Arguments for monopolies
Arguments against monopolies
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Collusion practices
Collusion involving a formal agreement among competing firms, where there is a
small number of sellers distributing a homogenous product may be defined as a
cartel.
In most economies cartels are illegal, however do exist on a global level since
international laws are inadequate insofar as brining about prosecutions.
The formation of a cartel relies upon:
a) Firms in the cartel must be able to control supply to the market.
b) The firms must agree on a price and on the output each should produce.
c) There should be barriers against new suppliers entering the industry.
The success of a cartel will depend on:
a) The number of producers in the market comprising the cartel.
b) Availability of substitutes.
c) The ability to restrict supply.
d) Price elasticity of demand.
e) The ability of producers to agree on their share.
Approaches to competition policy
Overall the aim of competition policy is to prevent undesirable outcomes that
typically derive from the abuse of market power.
Vs
Rules
Approach
Discretionary
Approach
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EXTERNALITIES
An externality is a cost or benefit that is not reflected through prices. It is
incurred by a party who was neither the buyer or seller of the goods or services
that gave rise to the externality.
The cost of an externality is a negative externality or external cost, while the
benefit of an externality is a positive externality or external benefit.
DISCUSSION 1
Discuss and categorise the following as to whether they give rise to positive or
negative externalities?
Pollution
Vaccination
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The below diagram illustrates the notion that the free market would determine
equilibrium at point Py,Y.
In the absence of government intervention a polluting factory would not factor in
the full social costs of production when deciding what level of output to produce.
Were a tax imposed on output, such that the tax revenues raised go towards off-
setting any environmental damage, this would cause the supply curve to shift left,
which in turn would reduce overall output, leading to a more socially desirable
outcome at Px, X.
$
Quantity
D0
S1
Py
Px
X Y
S0
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GOVERNMENT INTERVENTION
Public goods
The definition of a public good derives from the following criteria
Excludable Non-Excludable
Diminishable Private goods Common goods
Non-Diminishable Club Goods Public goods
EXERCISE 2
Categorise the following according to the above table: Lighthouse, Club Sandwich,
Internet, Fish Stocks.
Excludable Non-Excludable
Diminishable
Non-Diminishable
The common mistake when classifying public goods is to confuse those goods
E.g. Healthcare (National Health Service in the UK). Healthcare is both excludable
and diminishable!
Merit goods and de-merit goods
Merit goods provide positive externalities, whilst de-merit goods provide negative
externalities.
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Governments therefore attempt to increase the consumption of merit goods whilst
discouraging the consumption of de-merit goods.
Crucially, merit goods differ from public goods insofar as they could be supplied by
the free market, however despite perfect knowledge, consumers would buy a sub-
optimal quantity.
Merit Good
De-merit Good
DISCUSSION 2
What measures might a government undertake to encourage education and
discourage smoking?
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INDIRECT TAXATION AND SUBSISIDIES
Indirect taxes
Indirect taxes are levied on expenditure on goods or services, as opposed to direct
taxation which is applied to incomes.
Indirect taxes may be used to improve the allocation of resources when there are
damaging externalities, causing the supply curve to shift to the left as previously
discussed.
Exam questions often pick up on the notion of who the tax burden will affect the
most, producer or consumer. This will depend on the relative elasticity of demand
and supply. Consider the following extremes as to whom incurs the tax burden.
Demand more in-elastic than supply -
Demand is more elastic than supply -
D0
S0
$ S1
Qty
D0
S0
$ S1
Qty
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Subsidies -
A subsidy is the payment to the supplier of a good by the government. Reasons for
government subsidy payments may include:
a) To encourage the production of a good.
b) To keep prices at a socially acceptable level.
c) To protect a vital industry.
The impact of a subsidy mirrors that of an indirect tax!
Beware of the relative elasticity of demand and supply when interpreting the overall
impact from a subsidy.
$
Quantity
D0
S0 S1
P1
P2
Q0 Q2
P0
Subsidy
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GOVERNMENT REGULATION
Governments intervene in microeconomic matters when market forces do not
produce the outcomes they desire.
Government response to market failure
Monopoly elements - controls on prices or profits and breaking up monopoly
companies.
Externalities regulations.
Imperfect information product safety rules, public announcements, provision
of job centers.
Social reasons regulation to ensure access to goods such as healthcare,
education and housing.
However, the most extreme form of intervention is nationalization, which may be
undertaken for a number of reasons!
Privatisation
Over the past twenty years there has been a trend away from state intervention,
s entailed:
1. Deregulation allowing private firms to compete with state owned
companies.
2. Contracting out of government work previously done by government
employees.
3. Outright sale of businesses to private shareholders.
Public private partnerships (PPP)
As dis -way-
combining the benefits of state provision and private sector funding.