EconomicsNotes

 This post is a little less objective than usual, but might be of interest to those doing OCR, pre-U, or CIE-style argumentative essays on economics, as well as of general interest. It will be available as a podcast on one of my other blogs soon.   A working knowledge of economic theory (and practice) would be useful to policy stakeholders such as executives, legislators, the media, and the political classes, in three ways. Firstly, economics conveys a sense of the contingency of economic prescriptions, and therefore would help to illuminate policy choices, which could then be made on an informed, balanced, and persuasive basis. Secondly, a knowledge of microeconomic realities could benefit policymakers in dealing with supply-side matters and labour markets and help to stabilise and improve long-term growth. Thirdly, a great many economic problems are systemic and cyclical, and yet steady and long-term policies to expand aggregate supply, maintain real interest rates, and improve produ

  Employees can be protected by government intervention from the behaviour of businesses in a number of ways. Governments could, for instance, set minimum levels of pay, holiday entitlement, and protected sick leave for employees. They could define the processes whereby employees are disciplined or dismissed. Governments could regulate the entitlement to healthcare, pensions, or insurance of employees in such a way as to protect employees. They could set minimum redundancy standards for employees who were being laid off. They could protect employees whose business was transferred to another employer because of a merger or takeover. They could set rest periods, define times when employees were not expected to work, and attempt to balance the power of employers against employees so that the latter were not in an impossible position. Governments could also intervene to guarantee a right to trade union membership, to strike, to protest against company policies, not to be subjected to r

  Oligopolies are interdependent. This means that they follow the actions of the small number of other large firms in their markets closely. Since an oligopolistic firm faces a kinked demand curve, its directors know that cutting prices will usually not result in a gain of customers greater than the loss of revenue. This is modelled in the oligopoly graph whereby the AR (demand) curve slopes slightly but inelastically downward after the ‘kink’ point at which customers cease to be concerned with price, leaving the MR line to tumble straight down. The most rational, but usually illegal, way for oligopolies to avoid the danger that other firms choose to cut prices in a way that makes consumers price-conscious, and which thereby breaks both the kink and the level of profit enjoyed by firms, is to collude. If firms form a cartel and fix prices by agreement, consumers have no choice but to pay the price the cartel sets. Cartels depend on firms controlling supply and sticking to agreements,

  Profit is a positive difference between revenue and cost. Firms maximise profit where they neither make nor lose money on the last item produced and sold. This is the level of production where marginal cost is equal to marginal revenue. The actual amount of profit in such circumstances will be defined by the difference between average cost and average revenue at that level of production.   Economics also makes a distinction between normal, break-even, and abnormal (sometimes called supernormal) profits. Normal profit is the level of profit at which a firm covers its opportunity cost, usually defined as what it could have earned by doing something else with its money in the same time period. Break-even is an accounting concept in which a firm’s revenues are equal to its costs and is usually treated as the same thing as normal profit by economists. Abnormal profit is what most people understand as profit, which is a surplus of cash over spending. Economic theory does not assume tha

  The market system is one in which attempts to answer the basic economic problem of resource allocation in a world of scarcity by employing the price mechanism. In such a system, market price is used to allocate resources, to signal to producers and consumers what to produce and what is available, and to provide an incentive via profits and consumer surplus to sell or buy.   This means that the market will, via an ‘invisible hand’ be expected to clear the market, by selling all available goods at the prevailing price that people are willing to pay. This is contrasted with government schemes which seek to take advantage of concentrated information to make choices according to a national plan which is then imposed on producers and consumers. It has been recognised for centuries that the market system can be ‘allocatively efficient’ though it rarely is fully so.  Allocative efficiency is a state in which an economy produces goods so that the marginal cost of the producer is equal to th

  A firm’s costs are made up of fixed and variable costs. Fixed costs do not change with output, and therefore fall when averaged. Variable costs do change with output, and will eventually always increase because of rising marginal costs, which in turn cause returns to diminish with each extra item of output before becoming negative.   The lowest point of each short-run average cost curve forms a point on the long-run average cost curve (the short run being the period when at least one factor of production is fixed and the long run being that when all factors can be varied.) It follows that there will be a point on the Long-run average cost curve when a firm reaches its lowest LRAC, and that the LRAC will have been falling as each successive SRAC falls ‘downwards’ along it.  The explanation for why this process occurs is not linked to any one cause, and could involve falls in wage, raw material, regulatory, or business costs.  They could also be the result of economies of scale resul

  A perfect market is one in which an homogenous product is freely traded to sovereign consumers. Perfect knowledge and perfect information exist, so that all sellers, of whom there are many, know the production and sales techniques of all others and can replicate them, and all consumers know where they can always obtain the cheapest products. There are no legal, supply chain, or cost barriers to entry or exit into the market, and consumers are completely elastic, so that average revenue is equal to marginal revenue at the equilibrium price. The price is set purely by the meeting of supply and demand. In such circumstances, normal economic rules apply. Consumers would be seeking to maximise their utility and producers would be seeking to maximise their profits. Profit is the difference between revenue and cost and is maximised where marginal revenue is equal to marginal cost. This means that in a perfect market all profits are normal profits. Firms will only operate to cover opportun

  Economic theory holds that competition between many small firms, with no barriers to entry or exit and an homogenous product, is an ideal state. This is because the consumer will be sovereign in such a situation, and each individual firm will face an horizonal AR and MR line corresponding to the market equilibrium price. In order to exist and make normal profit, a firm will therefore push costs down to the lowest average cost or leave the market, which is also the point where average cost will equal marginal cost and marginal revenue. This will result in allocative and productive efficiency and create an incentive for anyone with innovative ideas to temporarily push costs lower, making an abnormal profit. In the long run, however, since perfect knowledge and perfect information might exist in such circumstances, every supplier will copy the original breakout firm, and customers will gain more goods at a lower price because of the increase of supply. In this perspective, mergers—ei

The theory of oligopoly is focussed on a stable market in which a few large firms dominate the supply of items and can have power over price or supply. This may be because of economies of scale or high barriers to entry. Barriers to entry can include sunk costs, legal and regulatory protections and requirements such as patents or performance rules, and resource availability. Within such a market, the theory assumes that the Demand curve for the individual firms corresponds to their Average revenue curves. These lines are ‘kinked.’ This means that the AR is inelastic and stable below a certain price point, because customers are not purchasing below the kink based on price, and elastic above the point, because the customers are price sensitive. Very few oligopoly models assume that the AR line is vertical below the kink, which means that there is some scope for different prices at different levels of output. Given that customers are highly inelastic, any price cuts would nevertheless