chapter 8 competition, market failure and gov’t intervention
DESCRIPTION
It's Chartered Institute of Management Accountants Course: C-04 Fundamentals of Business Economics ,Class LSBF Manchester ,Q's By Teacher Micheal Mubaiwa.TRANSCRIPT
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Chapter 8
Competition, market failure & government
intervention
CHAPTER 8 COMPETITION, MARKET TERVENTION
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CHAPTER CONTENTS
LEARNING OUTCOMES -------------------------------------------------- 89
BUSINESS INTEGRATION ----------------------------------------------- 90
MEASURES OF MARKET CONCENTRATION ---------------------------- 91
MEASURING MARKET CONCENTRATION 91
MONOPOLIES, COLLUSION AND COMPETITION POLICY ------------ 93
EXTERNALITIES ---------------------------------------------------------- 96
GOVERNMENT INTERVENTION ----------------------------------------- 98
INDIRECT TAXATION AND SUBSISIDIES ---------------------------- 100
GOVERNMENT REGULATION ------------------------------------------- 102
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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
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 two main 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);
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.
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Exercise 1
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.
Note: Using the Herfindahl Index the output will vary between 0 (perfect
competition) and 10,000 (pure monopoly).
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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
1. Product differentiation
2. Exclusive control
3. Economies of scale
4. High start-up costs
5. Cartel agreements
6. Geographical barriers
Monopoly Duopoly Oligopoly Monopolistic Perfect competition
$
Quantity
D0
Competitive
supply
Monopolistic supply
P1
P2
Q2 Q1 Z
Profits gained
Profits lost
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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:
The number of producers in the market comprising the cartel.
Availability of substitutes.
The ability to restrict supply.
Price elasticity of demand.
The ability of producers to agree on their share.
Arguments for monopolies
Arguments against monopolies
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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 nor the 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 to be 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
A common mistake when classifying public goods is to confuse those goods
Eg Healthcare (National Health Service in the UK). Healthcare is both excludable
and diminishable.
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Merit goods and de-merit goods
Merit goods provide positive externalities, whilst de-merit goods provide negative
externalities.
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 who incurs the tax
burden.
Demand more inelastic 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:
To encourage the production of a good.
To keep prices at a socially acceptable level.
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. Two further forms of intervention include:
Privatisation
Over the past twenty years there has been a trend away from state intervention,
with the growth of the private sector. s included:
Deregulation allowing private firms to compete with state owned companies.
Contracting out of government work previously done by government
employees.
Outright sale of businesses to private shareholders.
Public private partnerships (PPP)
As discussed in chapter 1, Public Private Partnerships are a form -way-
combining the benefits of state provision and private sector funding.