Economics in Minutes
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Profit maximization
Economists view firms as profit maximizers. Their decisions about how much to produce, how many workers to hire and where to buy their raw materials are all aimed at maximizing profit – the difference between total revenues and total costs. This may seem obvious, but it is not the only objective that might influence a firm. For example, a manager might aim at expanding the size of the firm so as to boost revenues, but this might not maximize profits if overall costs rose significantly.
When firms set output to maximize profits they make ‘marginal’ calculations: they compare the extra revenue and extra cost from one more unit of output. Suppose the ‘marginal revenue’ for a clothes firm from producing an extra shirt is £10, while the ‘marginal cost’ is £7. The firm will produce this extra shirt because it adds more to revenue than to costs, increasing profit. The firm will keep producing until the marginal revenue from an extra shirt is equal to the marginal cost of producing it – a production level at which profits are maximized.
Ownership and control of firms
The recent controversies over corporate bonuses and executive pay connect with a broader debate about how firms are managed. With the rise of the modern corporation, ownership and management of firms has become separated: companies are owned by their shareholders, but they are run by professional managers, and the interests of shareholders and managers do not necessarily coincide. Shareholders want high profits as this increases their wealth, while salaried managers might be less concerned with the profit of the firm as a whole than with their pay and perks.
In this case, the question is how best can shareholders monitor managers and get them to act to raise the value of the firm? This is far from straightforward, particularly when a firm is owned by a large number of small shareholders with little detailed knowledge of its day-to-day operations. With so many shareholders it can be hard for them to organize and respond to the actions of management when things go wrong.
Public companies and limited liability
A public company or corporation is one that issues shares that can be freely traded on the stock market, and benefits from what is known as limited liability. If such a company goes bankrupt, its creditors will seek to recover what they are owed by the company, but the individual owners of the firm cannot be held personally liable for the losses: they may well lose whatever they invested in the company, but creditors have no claim on their personal wealth. This is possible because, in law, corporations are treated as ‘legal persons’, with rights and obligations distinct from their shareholders.
Suppose you held a few shares in the bankrupt company, but had little knowledge of how it was being run. Limited liability enshrines the principle that you shouldn’t lose your house because of mistakes that may have been made that led to the company’s demise. This lowers the risks of making investments in firms about which one may have little knowledge, and so helps expand financing opportunities for companies.
Production functions
Economics has surprisingly little to say about the operation of firms: it considers them merely as entities that convert a set of inputs – capital, labour and skills – into output. The production function is a mathematical representation of this: it might indicate that if a textile factory had 10 looms and 10 workers it would produce 100 metres of cloth per day. It also tells you what happens when inputs change. For instance in this example inputs have to be deployed in fixed proportions: one worker to one loom. If the factory installs an extra loom, it will only increase output if it hires another worker to operate it.
Other kinds of production allow a choice between capital and labour: a farmer might choose to produce 10 tonnes of grain using tractors and a couple of drivers, or hiring many labourers to work by hand. The production function also describes what happens to output when inputs are scaled up. If inputs double and output more than doubles – perhaps because scale allows specialization – the firm has ‘increasing returns to scale’.
The law of diminishing returns
The law of diminishing returns states that the effect on output of additions of labour or capital falls as one increases these inputs. Consider a farmer employing a single worker on his field. The overworked labourer produces 50 cabbages a season. By adding an extra worker, the farmer may get 150 cabbages from the field. He keeps adding workers until eventually he has 30 workers producing 2,000 cabbages at every harvest.
What would be the effect on output of adding an extra worker to this workforce? Output may well increase, but by much less that the extra 100 cabbages that came from increasing the workforce from one to two workers. By the time there are 30 workers there is so much labour working on the land that the impact of an extra worker is small. There might even be a point at which there are so many workers that they get in the way of each other, so that hiring an extra worker actually reduces output. Hence, the old saying ‘too many cooks spoil the broth’.
Average versus marginal cost
An important distinction in economics is that between average and marginal amounts – for example, average versus marginal cost. Suppose that a furniture manufacturer makes 100 tables at a total cost of £1,000. The average cost of manufacture is then £10. However, the cost incurred from making an additional table is not necessarily £10. If it is more than £10, then production of the extra table will push up the average cost; if less, it will pull it down. This is analogous to the scoring average of a football player – if in his next game he scores more goals than his average, his average score will rise.
Often the marginal cost of production rises with output because it becomes harder to squeeze out extra output when one is already producing a large amount. In making a decision about whether to produce an extra table, the firm must consider marginal rather than average cost: if marginal cost is less than marginal revenue, then it is profitable to produce an extra table.
Marginal and average costs
When marginal cost is below average cost, average cost is falling and when marginal cost exceeds average cost, average cost is rising.
Economies of scale
As a car firm produces more cars, the average cost of production per car varies. Increasing production from low levels, the average cost per unit will fall – a phenomenon known as economies of scale. Why should this be the case? Car production is highly capital intensive, requiring a large initial investment in factories and machines. As more cars are produced, these fixed costs get spread over greater output. In order to make use of its assembly lines, the firm also needs workers specialized in particular tasks – this improves efficiency and lowers average costs when production is high.
It is also possible for production costs to rise rather than fall as output increases. This might happen when the firm is producing so many cars that it is hard to coordinate different parts of the firm. Different departments may not know what the others are doing, perhaps leading to the duplication of efforts. Such a situation gives rise to so-called diseconomies of scale.
Sunk costs
In any economic situation, many costs can be considered ‘sunk’: once they have been incurred, they cannot be recovered. Suppose Dave buys a ticket to a play. On arriving at the theatre he realizes that the performance is Macbeth – not one of his favourite plays. It is too late to get a refund, but as he’s spent £20 on the ticket, he decides to watch the play anyway. However, Dave’s £20 is a sunk cost: he’ll have incurred it whether or not he watches the play, so he should really write it off and decide what he’d prefer to do now – even if that is going home to watch television.
Similarly, sunk costs shouldn’t affect how much a firm supplies today. A swimming pool owner has incurred sunk costs – the cost of land, the construction of the pool and so on. On cold days there may be only a handful of swimmers, but it might still be worthwhile to keep the pool open because the major costs are sunk and the owner might still make some money from the small number of customers.
Division of labour
The division of labour is an important source of productivity improvement. Adam Smith argued that it is what drives the growth of economies as markets expand and firms specialize in particular goods. Today, the division of labour and the ‘production line’ approach extends globally, as producers outsource the manufacture of components to overseas firms.
Perfect competition
A perfectly competitive market is one with so many buyers and sellers that no one of them can influence the price. In this kind of market, everyone sells exactly the same good – perhaps a commodity like corn or salt. If I buy some corn, then because there are so many buyers my purchase is a drop in the ocean of overall sales and will not influence the price. If a seller raises her price, no one will buy from her, and if a buyer tries to pay less than market price, the seller will find another customer. Buyers and sellers are therefore ‘price takers’.
Another important requirement for perfect competition is that any firm can enter the market and compete for business with existing firms – for example, there must be no legal restrictions or difficult technological requirements to prevent firms from entering. Economic theory says that perfectly competitive markets encourage efficient use of resources, but of course many markets fall far from this ideal, containing monopolies or significant entry barriers.
Monopolies
When there are many firms in a market they compete and keep prices low. Suppose that prices and profits were particularly high in some industry. This would attract new firms who would enter the market and compete prices down. A monopoly is the opposite case – one firm controlling an entire market.
A monopoly can arise when there are high barriers – perhaps technological or legal – to competitors entering. Because the monopoly controls the entire market it can set the price of the good or the quantity supplied. Economic theory says that monopolists restrict output relative to what would be produced in a competitive market, leading to higher prices and greater profits. Economists tend to be critical of monopolies because consumers lose out compared to the higher output that would emerge in a competitive market. This is one of the justifications for competition policy, which aims at restricting the formation of monopolies.
Natural monopolies
Some goods tend naturally to be supplied by monopolies – usually those which see lower average costs of production as output goes up. Distribution of electricity is an example of such a natural monopoly: setting up a distribution network – underground cables, pylons and so on – is very costly, and because of the high initial cost, the more electricity is distributed, the lower the average cost. This means that a single firm operating an electricity network is far more cost-effective that two competing firms each operating their own distribution networks.
Given economies of scale, competitors are unlikely to enter such a market of their own accord, and breaking up a natural monopoly into competing firms might not be efficient. However, the power of monopolies may allow them to raise prices, so governments have an important role to play in limiting prices, particularly for utility suppliers. As a result, most governments tend to regulate, rather than break up, natural monopolies.
Oligopolies
When there are many firms in a given market, competition keeps prices low, while under a monopoly, output tends to be lower and price higher. But what about the intermediate case of an ‘oligopoly’ involving a small number of firms? In the ‘perfect competition’ model, there are so many firms that no single one can affect the price – firms produce on the basis of market price and don’t worry too much about their competitors. Oligopolistic firms, however, are in a situation of strategic interaction: each firm’s actions affect the price and the profit earned by others. So in making decisions about prices or output, firms have to consider how their competitors will react.
French economist Antoine Cournot analysed the case of two rival firms interacting by choosing output given their best guess of their competitor’s output. He showed that combined output would be higher than that in a monopoly, although lower than that in a perfectly competitive market. In other words, some competition is better then none.
Monopolistic competition
Many companies sell soap. Each brand is slightly different but competes with the others: this is the essence of monopolistic competition. A consumer typically favours a particular brand of soap and is willing to pay more for it. This gives the manufacturer of that brand some market power: the firm could raise the price of its soap slightly without losing all of its customers. However, such market power has clear limits. Although the brand has special features, it is in competition with other brands. If the company raised its prices too much, customers would switch to other brands of soap.
So monopolistic competition combines elements of monopoly and competition. These firms have some market power and so don’t charge the low prices that emerge when many firms compete to sell an identical product. On the other hand, because they are in competition, they cannot charge the kinds of high prices that a monopoly would. Such markets also offer product diversity, which is valued by consumers.
Under monopolistic competition, firms produce where average cost equals average revenue, as entry by other firms competes away profits.
Cartels
In competitive markets, firms compete for business and offer low prices. Monopolies, conversely, produce less, charge more and make higher profits. So what if competing firms could club together and act like a monopolist? Such an arrangement is called a cartel. If members of the cartel restrict supply to keep prices high, all can make higher profits. In many countries such arrangements are illegal. However, some cartels take on an international dimension, such as the Organization of the Petroleum Exporting Countries (OPEC), a prominent cartel of oil-producing countries formed in the 1960s.
Cartels face a ‘collective action’ problem. Suppose OPEC countries boost the price of oil by restricting production. Now an individual oil producer, say Venezuela, has every incentive to produce a little more oil to sell at the higher price. If Venezuela faces this incentive, then so do the other countries, but if they all raise production, the price falls and they undercut their original aim. This is why cartels are prone to instability.
Price discrimination
A firm sells razors for $3 a pack, and its customers show considerable variation: those who value a close shave might be ready to shell out $4, while for others, $3 is the upper limit of what they are willing to pay. Is there a way for the firm to discriminate between these two kinds of consumers, in order to charge them different prices? If it could charge the particularly close-shaven men $4 and the rest $3 then it could boost its profits.
This sort of ‘price discrimination’ can be hard to do: even if the firm could distinguish between the groups, the less fastidious men could buy the $3 razors and sell them to the close-shaven men for $3.99. So successful price discrimination requires that different groups of consumers can be identified and separated so that one group can’t just sell on the good. Student and pensioner reductions for haircuts are one example: concession status indicates that a person may be less willing to pay than average, but a service such as a haircut cannot be sold on.
Predation
The market power of a monopolist is said to be undesirable because it leads to higher prices. But market power can also be exercised through price cuts. Some argue that such ‘predatory pricing’ is
anti-competitive and that anti-trust agencies should try to prevent it. Suppose that Whizzy Bus is the only bus company on the London–Manchester route and earns hefty profits from its monopoly. Seeing an opportunity for profit, Zoom Routes now introduces a London–Manchester bus service. Whizzy responds by cutting prices, trying to drive Zoom out of the market. With healthy competition, fares would likely fall anyway, but Whizzy’s strategy of predation goes further, slashing prices below the competitive level. In fact, Whizzy cuts prices below costs, hoping to recoup its losses from future monopoly profits. Whizzy calculates that Zoom would rather exit the market than bear the losses needed to compete. Distinguishing competition and predation is tricky. Moreover, it is unclear when predation is likely to be successful, since the predator itself may need to sustain huge losses.
Entry barriers and contestable markets
For a monopoly or a small number of dominant firms to sustain profits over time, there have to be barriers to new firms entering the market and competing with lower prices. Such barriers are often inherent to particular kinds of production. For example, entry to markets that need huge initial capital outlays and a large scale of production from the outset to pay for it may be hard. The production of some goods might need access to specialized technology that is not freely available, perhaps protected by a patent (see Patents). Sometimes existing firms have built up such brand loyalty and reputation that it is difficult for newcomers to compete.