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Module 2881 Industrial Economics

Unit 4: “The Theory of Production & Costs”


The Birth of Firms

Firms usually start small, often as a one-person concern or a family concern.

According to Barclays Bank, some 465,000 new firms started up in 2003 alone. Sadly,
many of these are doomed to fail. According to government statistics, in 1997, the
business survival rate for new firms was only 65.1 per cent after three years; one third
had disappeared in that period. About half of these close down voluntarily, and about a
third sell the business to another firm.

In many cases they are undercapitalised, and the firm simply runs out of money and
cannot borrow any more. In some cases it is a management constraint, in that the
person is ambitious but not talented or skilful enough. Virtually all firms have to
borrow to invest and grow.

Why do firms wish to grow?

The usual motives are:

To make higher profits.

To establish a business that will see them through life.
To leave a legacy for their dependents and perhaps to establish a dynasty.

Reasons for success are harder to pin down, but include:

Sufficient capital to tide the firm over a bad patch.

Access to funds.
Good contacts.
Willingness to work long hours.
Developing a strategy to overcome local or regional disadvantages in location.
Developing a niche market or a unique selling point.

The desire for to grow leads firm to try to increase their share of the market. The really
successful ones may gain economies of scale and a few might become monopolies or be
large enough to compete with the big boys.

Copyright Kevin Bucknall © 4-1


1. Profit maximisation.

In economic theory, the main motive for a firm is to maximise profits. This is central to
mainstream theory. It involves equating marginal cost with marginal revenue, whatever
the market situation the firm is experiencing.

2. Revenue maximisation

This is another suggested goal. It would be possible for a firm to survive following this
goal but it would grow more slowly and always be a bit at risk. A lusty profit
maximiser could seize an increasing share of the market, possibly driving the revenue
maximiser out in the longer term.

Using our diagrams, instead of the firm seeking the point where MC=MR as a profit
maximiser would, the revenue maximiser keeps expanding output as long as marginal
revenue is positive. It ceases to be positive where it cuts the horizontal axis at Q in the
diagram below. As soon as it becomes negative, total revenue would start to fall, so the
firm stops.

Price, costs,

Q Quantity
0 MR
In the above diagram, the revenue maximising quantity is thus OQ and the price is then
read off the demand curve: the firm chooses price OP.

Because the firm reduces price until marginal revenue becomes negative, there is an
implication for the elasticity of demand. If a price reduction leads to an increase in total
revenue, we know that demand is elastic. If a price reduction leads to a fall in total
revenue we know that demand is inelastic. As we switch from increasing to falling total
revenue, the elasticity of demand must be neither – it is unit elastic at that point.

3. Sales maximisation

This is a third suggested goal. It suffers from the same problem of the revenue
maximisers, in that the firm is vulnerable to profit seeking competitors.

Such a firm will expand output until the average cost curve intersects the demand curve,
as in the diagram below.

Price, costs,

Q Quantity
0 MR
The firm produces OQ level of output and sells it for price P. This price is lower than
the profit maximiser’s price, or the revenue maximiser’s price – as one would expect as
more sales is what it is all about.

A variant of this model is that the firm may concentrate on maximising sales in the
short term in order to gain a larger share of the market so that in the long term it can
earn more profits by switching its goal. It is a sort of long term profit maximiser using
the route of short term sales maximisation!

Another business variant model of the sales maximiser is that it is possible that when
the firm becomes large, managers are taken on and they may prefer to maximise sales
rather than profits. The shareholders would generally prefer higher profit but they have
little say in day to day running of a company.



A firm may grow by merging with, or taking over, another firm. There are two
directions in which it can do this: horizontal and vertical. These refer to the position of
the other firm within the structure of the industry.

Horizontal mergers

This is when a firm merges with another at the same level within the industry. As an
example, if one video rental firm takes over another video rental firm. In effect they
exist at the same level and they do the same things. They are probably directly in
competition with each other, although some may be located differently. A recent
example of this occurred in 2004 when the supermarket Morrison took over Safeway;
Morrison was strong in the north of England but lacked southern outlets. It is, as you
would imagine, difficult for a supermarket to obtain suitable land in or near cities, so
that a take-over or merger is the simplest way of expanding into a new area.

Vertical mergers

This is when a firm takes over another which is earlier or later in the production process
within the industry. As an example, a wholesaler of shoes might take over a shoe shop
or chain of shoe shops, in order to provide itself with outlets. This is an example of
forward merger. If it were to take over a shoe manufacturing company, it would be an
example of backward takeover. A current example of a backward merger is the effort
in 2004 by the American Wal-Mart company, trading in Britain as Asda, to develop a
close partnership over a section of the milk supply industry at the farm level.
Some such mergers are an effort to reduce risks and establish a safe source of supply or
outlet chain.

However, many backward mergers by a dominant firm are an effort to reduce

competition and perhaps lead to a later take over the whole industry. Once a wholesaler
owns an important manufacturing unit it can deny the produce to its own more direct
competitors or make them buy on less advantageous terms. There are fears that Asda’s
recent efforts in the milk chain supply industry could lead to a less competitive

Conglomerate mergers

This is where a company in one industry takes over one or more companies in a totally
unconnected industry. The result will be a conglomerate, or a company which spans
several unconnected industries. A contemporary example is Richard Branson’s Virgin,
which began as a mail order record retailer, then opened a retail store and branched out
into running railway trains (Virgin Rail) and airlines (Virgin Airways). He is also in to
book publishing, software publishing, clubs, travel, hotels, and cinemas. Some of these

have loose connections, others none. In all he now owns over 150 companies and
claims that they all make money.


Multinational corporations (MNC’s) have grown in importance as globalisation

proceeded and they are a factor in encouraging the globalisation process. An MNC is
typically a huge corporation spanning several continents with one home base, which
might be in the UK, the USA, Holland, France, Japan…. it can be anywhere but is
almost always in the country in which it first began. Some are the result of mergers,
horizontal or vertical, as a company in country A takes over an existing company in a
different country. Others are the result of the original company in country A investing
money in country B to build a factory or firm there.

You will certainly have heard about a lot of MNC’s, even if you did not know that
this is what they were! Well-known examples are Ford (motor vehicles), Unilever,
Sony, IBM, Philips, and Reckitt and Colman.
These large companies have huge sums to invest and the world is their oyster. They
often try to locate production where the manufacturing costs will be low, so recipient
countries include places like China, India, Indonesia, Pakistan and Thailand. Various
service centres will normally be established to cover the different parts of the world.

In the last half of the twentieth century, globalisation was rapid. It was assisted by a
huge fall in the costs of communication and finding information, as well as by tariff
cuts and quota reductions or elimination. MNC’s took advantage and grew rapidly as
part of this; in addition they were responsible for pressuring governments to take
action, such as tariff cuts, which helped the MNC’s to expand. By the end of the last
century, trade between multi-nationals themselves has been estimated to account for
one third of world trade, and another third is made up of trade by MNC’s with non-
affiliates. They are indeed major players!

We return to look at MNC’s, what they do and the arguments for and against them in
Unit 6.


Production theory underlies all the theory of the firm, it is related to resource
allocation, and it is where we get the supply curve from.

We assume for simplification:

A one-product firm.

We can identify land, labour and the units of capital used, as well as costs.

Land, labour and capital are homogeneous, which means they are all identical.

Firms aim to maximise profits. Other models do exist, e.g. sales maximisation,
but they are not a part of central economic theory.


Profits are not a dirty word!

But what some people will do for profit can be very dirty indeed! It is alleged that the
Mafia in the USA will give you a cheap quote for removing and dealing with your toxic
waste - then they might just tip it into reservoirs to get rid of it, and not spend the
money to do it properly.

The function of profits: (what are they for?)

Profits are a signal - a high rate of profit in an industry is a signal that society values
that particular good or service highly and will pay a lot to get it. This tells us that more
resources should go into this industry that society values so much. Individual firms
move in to get the profit and as a result, resources automatically go where they are
needed. Adam Smith was the first to see how a market economy allocates resources
and publicise it; and this process was what he meant by “the invisible hand”.

Losses are a signal that too much is being produced, that is, output should be reduced.
This means that firms ought to leave that industry, as society does not value that good
or service so highly. Where profits are falling in an industry, it often means that
demand has altered away from that good or service. The lower profits encourage some
business people to move out.

The law of diminishing returns says that if one factor of production is increased,
while holding all other factors constant, then after a point, the additions to output will
start to fall and ultimately total output will decrease.

As an example, if you were to take your back garden and turn it to growing potatoes,
you might start, say, with five people (N) plus five spades (K) and your garden (L).

The resulting output may be 100 kg p.a. of King Edward’s potatoes.

If you add a 6th person output (but no more spades or land) output might increase to
180 kg – the new person can weed or water while the others dig, etc., so output will
rise. The addition to total output is then180-100 or 80 kg. This is the marginal product
of the sixth person.

If you add a 7th person, output would still increase, perhaps to 250 kg – the addition to
total output is 250-180 or 70 kg, which is the marginal product of the seventh person.

You can see the 70 kg just added is less than the 80 kg added earlier - i.e., the addition
to total output from last person employed is falling, which is to say that returns are

You might object that these figures are merely invented – which is true. But think! By
the time you get to the 200th person, standing in your back garden and only five spades
to work with, output is not going to be large! It is probably zero, in that there is no
room to plant, dig or anything as your garden is wall-to-wall people! At some earlier
point, output must have reached a maximum then fallen to nothing.

The point where output was at maximum might have been around the fifteenth or
twentieth person, and after this, more people began to be a nuisance. The new person
might start to gossip and distract the others; or perhaps they trip over the new comer
now and then, so that output actually fell a little after he was employed. When total
output starts to fall, the marginal addition is negative, and total output starts to decrease
at that point.

This law must hold – we can always add enough labourers to completely fill your
garden, however large, and leave no room for growing potatoes at all. The same applies
to producing anything, for example, T-shirts. The table below shows a possible



Workers per day Output – T-shirts per Marginal product (T-shirts Average product (T-
day per worker) shirts per worker)
1 2 3 4 (col. 2 ÷ col. 1)
by (subtraction from col. 2)
0 0
1 4 4 (4-0) 4.00
2 10 6 (10-4) 5.00
3 13 3 (13-10) 4.33
4 15 2 (15-13) 3.75
5 16 1 (16-15) 3.20
6 14 -2 (14-16) 2.66
7 11 -3 (11-14) 1.57

You should observe that in the above table:

1. As we add labour, total product increases.

2. Marginal product rises at first, then falls steadily after that, and finally it becomes
3. When the marginal product is above the average product, average product is
increasing; when marginal product is below the average product, average product is

This is the property of averages, it has nothing to do with economics! When the amount
added exceeds the average, it must pull the average up.

Let’s take an example of a Premier League soccer team week by week and see the
average, total and marginal scores

Soccer Match: Average, Total, and Marginal Goals Scored

Match Goals Total goals scored Average goals Marginal goals

Number scored in (adding col. 2) per match per match
match (col. 3 ÷ col. 1) (col. 2)
1 2 3 4 5
1 2 2 2.00 2
2 4 6 3.00 4
3 1 7 2.33 1
4 0 7 1.75 0
5 3 10 2.0 3

If you examine the table you will see that when the margin is above the average, it pulls
the average up. And when the margin is below the average, it starts to pull it down.

It not only applies to a team scoring goals, or indeed any set of figures, it works just
the same way in production. We can graph this too!

As a firm adds labour, we can show the changes in marginal product (MP) and
average product (AP) in a diagram.

So looking at the T-shirt example the soccer scoring table you will see that the
information on totals, marginals and averages follows a similar pattern.

The average product and the marginal product curves




0 Quantity of the factor

We can also draw a diagram of the total product curve.

The total product curve

Total Output


Quantity of labour

Why is it that shape?

Before we hire any labour there will be no output, so the curve starts at the origin.

At first, it is easy to produce, we can get the necessary workers and staff we need easily,
and so the output curve increases and also accelerates upwards.

Later on, we will start to encounter problems, so the growth in output slows, then
reaches a peak, and finally will fall.

What sort of problems might be encountered? They could be things like:

We will start to run out of machinery (remember that we are only increasing
labour, holding other factors constant) so that the relationship between the
number of workers and the number of machines gets worse. In simple terms,
the balance is wrong. In the example of your garden, the workers ran out of
spades and had to find something else to do you will recall.

The emergence of bottlenecks in the factory – storage space for materials, semi-
finished and finished products perhaps.

Possibly the workers cannot find parking space nearby, which annoys them, and
they then feel disgruntled and lower their efforts. This would not be the law of
diminishing returns as such, but a loss of motivation.

The production function

The production function shows how many of the factors of production we must use to
get various different levels of output. In other words, it shows the relationship between
different inputs and the resulting output.

We can see production function in several ways:

1. We can see it in the generalised form

O = f (L, N, K) + R

(Which means “Output is related in some way to the inputs of land, labour, capital and
the catch-all remainder term”).

2. We can see it as the total product curve above. In the diagram, as we increase the use
of labour, we can watch total product increase. This is a simple, one factor model.

3. We can also see it as a box of choices, using two factors of production labour and

The production function as a box of choices

One question is how can we produce using the resources we have got? How shall we
combine them? (this is called “the choice of technique”).

The firm could use:

1) A lot of capital and a little labour; or

2) A lot of labour and little capital.

Engineering information gives us the figures in the box that might look like:

The Box of Choices

Capital (across)
Labour (down)
1 machine 2 machines 3 machines 4 machines
1 worker 9 18 26 33*
2 workers 20 27 33* 38
3 workers 26 33* 38 42
4 workers 33* 39 42 45
5 workers 35 41 44 46

You can see that we can produce 33 units of output in several different ways – the firms
will choose the cheapest method or the choice of technique to use, to maximise profits.

If wages are low (relative to the cost of machines) the firm would use as more workers
and fewer machines - four workers and one machine would do it (this is typical of a
developing country like Indonesia).

If wages are high (relative to the cost of machinery) the firm would choose to use more
machines and few workers – in this case two machines and one worker (this is typical
of a rich developed country like the UK or USA).


Some definitions:

Total Cost is what it says – total costs are all the costs of the firm (fixed + variable)

Fixed Costs are fixed, irrespective of output; they do not increase as output increases.
Examples are the salaries of the managerial staff, the interest paid to the bank on the
money borrowed, or the local council tax.

Variable Costs alter as output changes. Examples include the need to hire more labour
to increase production; and using more raw materials to go into the extra output.
Clearly the variable costs must rise as output increases.

Average cost is the total cost divided by output.

Marginal cost is the addition to total cost from producing the last unit of output [or one
more unit – it is at the margin.]

Price, Costs


0 Output

For all the theory of the firm, and all market conditions, the AC and MC curves
look the same – you can always start by drawing the AC and MC CURVES
without even thinking!

Why are the shapes that way?

When MC is below AC it pulls it down; when MC is above AC it pulls it up. This

means that the MC curve must cut the AC curve at the lowest point.

The AC curve is U-shaped because when starting to produce, the fixed costs must be
born by a few units of output, so average costs must be high; as the firm produces more,
the fixed costs are spread over more units of output, so AC falls. Then it reaches a
minimum. Eventually the firm is trying to produce more than it was designed for, and
average costs start to rise.

We can depict this as the mirror image of average and marginal products – as physical
output increases so costs fall, but as average product and marginal product fall, so
costs must rise.






Occasionally there might be a question in an exam asking about the relationship

between the two.


The theory of the firm covers perfect competition, imperfect (or monopolistic)
competition, and monopoly. These are increasingly less competitive in the order
listed. Oligopoly is considered to be something of a special case.

The Arrow of Competition:

Monopolistic competition


As just pointed out, all firm diagrams start the same way!

Price, Costs



The equilibrium position is where marginal cost = marginal revenue!

Why? Logic! If a firm is profit maximising, it continues an action, like expanding

output, until it costs more to do it than it brings in as revenue. As long as revenue
exceeds costs, it pays to go on doing it. As an example, if total revenue is £2,000 and
output is such that the last unit sold increased costs by only £1,500 it clearly added
£500 to revenue more than it cost to build and was worth doing. And another unit
might add £1,900 to costs but sold for £2,000 so was also worth it. The next unit,
however, might add £2,050 to costs but bring in £2,000 – a loss of £50 so it would not
be worth it. When the last unit just adds £2,000 to costs and brings in an extra £2,000
it is marginal – it makes no difference if we produce that last one or not.

So what do we know?

The cost at the margin (the addition to total cost from the last unit produced)
increases as production rises (the MC curve).
The revenue from the last unit sold is the marginal revenue (MR).
Logic tells us that the firm will continue expanding output and watching MC
rise until it equals what the firm receives from the marginal unit sold (MR).
Therefore when MC = MR it is the best the firm can do, so it stops there; it is
in equilibrium.

We use the MC curve to trace what happens if a firm changes its output level, for that
very reason.

PERFECT COMPETITION (the right hand end of the arrow above)

Perfect competition is defined as a situation where there:

Are many small buyers and sellers (firms) each too small to affect the price – the
firms are "price-takers".

Is a homogeneous product [all are identical].

Is free entry and exit. This means that firm can join or leave the industry – it is both
allowed and costs nothing.

Is perfect knowledge.

If we take out “perfect knowledge” (which never exists in the real world) and leave the
first three assumptions, we get "pure competition”. It is less than perfect, but is still very

The diagram of an individual firm:

Price, Costs



0 Ot1

Equilibrium is where the marginal cost curve, MC, cuts the price line, P1. In perfect
competition any of the tiny firms can sell more without having to lower its price – it is
too small to affect price! This means that the price line above is the marginal revenue
also. The firm always gets the same price at the margin.

The price line is also the average revenue in perfect competition. It’s just the maths.

Total revenue = P x Q

Average revenue = TR ÷ Q

Clearly if we multiply P by Q then divide the result by Q we must end up with P


Perfect competitors are price takers!

The price is set at the industry level by the total supply and demand curves, in the normal
way. Each firm must accept it – because the industry is made up of lots and lots of small
identical firms; none can affect price.

The price is set in the industry by the demand of the consumers cutting the industrial
supply curve. Where does this supply curve come from? We get it by adding up all the
MC curves of each little individual firm in the industry. All these MC curves added up
are the industry supply curve as long as we are in perfect competition!

How price is set at the industry level:

Price is set Each tiny firm accepts that price

in the industry
by S & D Tiny firm 1 Tiny firm 2
Price, Costs Price, Costs

P1 P1

0 0
0 Q1 Q Q

Quantity in millons Quantity in hundreds Quantity in hundreds

And the small individual firms are price takers because they are too tiny to be able to
change it - and there is no point selling it for less than they could get.

If demand for the product increases in the industry, it causes an increase in price and
firms move up the MC curve.

Q. Why the MC curve?

A. As was said above, because the firm is interested in increasing output as long as it
brings in a greater revenue than it costs to make the extra bit.

How an increase in demand in the industry affects the perfectly competitive


We first change the price in the whole industry as demand has increased then trace
this over to see what it would be like for an individual firm. The increased demand in
the industry causes price to increase; each small firm enjoys this sudden increase in
price - and of course its profit increases. The firm then increases output in order to
benefit from as a high a profit as it can manage.

Each tiny firm enjoys a higher price

Demand for - sliding up the MC curve
the product
increases Tiny firm 1 Tiny firm 2
D2 Price, Costs Price, Costs
P2 P2

P1 P1 P1

0 Q1 Q2 0 Q1 Q2 0 Q1 Q2

Quantity in millions Quantity in hundreds Quantity in hundreds

Above the equilibrium point where MC cuts the price line P1 (which is also marginal
revenue and average revenue as explained earlier), the firm makes more than its
normal profit. You can see that at P2 it is operating above the average cost curve.
Normal profit is built into the average cost curve – without it the firm goes bust!
Above the AC curve, the firm makes “excess profits” or “above normal profits”.
However, firms can earn above normal profit like this in the short term only.

Why is this? The above normal profit immediately attracts other firms to enter the
industry. After all, they have perfect knowledge which means they know about it!

And the free entry and exit proviso means they can race in! And this means extra
output, i.e., an increase in supply at the industry level, so price starts to fall back.
This process bids away the profits all the way down to where we started where MC =
MR = AC = P1. So in the long term, under perfect competition, no above normal
profits are possible.

Q. Can you take the diagram above, draw it for yourself, then increase the supply
curve until P2 falls back to P1? Try it now!

What happens if price falls below AC? At this level, all the firms lose money and
continue to do so until some firms go out of business. When they do, supply
decreases, so that price starts to increase, and this continues until the price is back to
the original equilibrium position.

Average variable costs versus average total costs

Average variable costs must always be covered (they go directly into the particular
item one is selling); but average total costs are different. Average total costs include
all kinds of things, like new toner for the computer’s printer – these do not go directly
into any particular item, they just have to be covered in the long run. So a firm can
continue in business in the short run, as long as average variable costs are covered,
even if average total costs are not. Anywhere between A and B in the diagram below,
the firms are covering the variable cost of production and earning a little extra
towards covering the long term total average costs. So it is worth staying in business
for some time and hope that market conditions improve (prices rise) so that they will
return to profitability. [This is a common multiple choice question].

Price, Costs




The advantages of perfect competition

Resources are allocated in the most efficient way to meet market demand and
maximise consumer satisfaction.
- This means that market mechanism works better.

It is the cheapest way of using the factors of production we have.

- Which says that we are at the lowest part of the AC curve.

There is no cost of advertising, selling, marketing, or motions. These are often a

form of waste to society as a whole, though beneficial for individual firms.

Rapid change is possible to meet new consumer demands – it is very flexible.

The interests of producers are the same as for consumers.

Freedom to choose exists.

It avoids all the wastes of monopoly.

It prevents the emergence of a few rich and powerful people (Conrad Black?
Robert Maxwell?) There are a lot of firms, all small, so that no major powerful
personality can rise and dominate others.

The disadvantage of perfect (or pure) competition

It produces what is demanded under the given distribution of income. We can

imagine a scenario with a very few rich people with pet dogs or cats which dine
extremely well on chicken and the like, while the masses starve.

Spillovers and externalities can exist. These are costs caused to others, e.g. the
disposal of nuclear waste or toxic chemicals by dumping them in streams.

No economies of scale possible - all the firms are too small.

Perfect competition is consistent with a limited choice of range of goods;

monopolistic competition may have a much wider range. An example is
motorcars – there are an awful lot of different models and competition is much
less than perfect.

Little or no research and development is possible because there are no funds for
it. Under perfect competition there are no surplus profits (in the long run they
are whittled away!) R&D is possible under monopoly because of the surplus
profits available.

hand end of the arrow of competition)

Monopolistic competition


(There is some overlap between Unit 2 and Unit 4 on monopoly, so this may seem
familiar to you.)


Definition: Technically it is a sole supplier, i.e., there is one firm in the industry. It is
the industry.

But there are degrees of monopoly - if one firm supplies, say, 80 per cent, it is close to a
monopoly and will usually act like one.

Types of Monopoly

Economies of scale. One firm grows large, its cost curves are lower than the
others, so it is able to sell more; in the end it grows to become the sole firm.
This is the so-called natural monopoly.

2a) The law. The government may restrict the industry to one nationalised firm.
An example was British Steel some decades ago in the UK.

2b) Regulations. A trade union may have a monopoly over the supply of one
kind of labour – the British Medical Association covers all doctors for instance.

Agreement between firms, so that they all act together and behave as one
monopolist. This is often illegal but it happens.

Exclusive ownership of a unique resource. As an example, all the known

supply of iron ore in Australia was once in the hands of a company called BHP;
similarly De Beers diamond mining once virtually controlled all (and still
controls a lot) of the international supply of diamonds.

Copyrights, patents and licences are particular forms of this exclusive


Marginal revenue and monopoly

Marginal revenue is the addition to total revenue from the last unit sold.

A perfectly competitive firm can sell as much as it wants at an unchanged

price. Its MR curve is equal to the price – every time it sells one more item it
receives, say, an additional 50 pence, which adds 50 pence to TR.
A monopolist is the industry, so it faces a normal downward sloping demand
So if wants to sell more of the good or service it must lower the price.
And of course it must sell all its products at that lower price. This means it
loses by selling the items it used to sell earlier at a higher price at the new
lower price.
So the price of the marginal product is not the MR – the firm’s total revenue
increases by less than this sale, because of the bit it lost on the price on all the
other products.

See the example in the table below.


1 2 3 4
(1 x 2) (by subtraction in 3)
1 7 7 7
2 6 12 5 (12-7)
3 5 15 3 (15 -12)
4 4 16 1 (etc)
5 3 15 -1
6 2 12 -3
7 1 7 -5

Note that marginal revenue is less than price for all quantities after the first one.

Monopoly equilibrium

Equilibrium is where MC = MR, as usual. When you are drawing the diagram and
answering questions you should locate that point first and draw it in.

Price, Costs


0 Q

Seeing monopoly profits in the diagram below

Profits = total revenue minus total cost.

Total revenue = price times quantity.
Total cost = average cost times quantity.

Total revenue = the area 0 P A Q.

Total costs = the area 0 AC B Q.

So profit is the difference between these two areas = P A B AC.

Price, Costs



0 Q

Problems with monopoly, “what is wrong with monopoly” or "the welfare effects
of monopoly"

A monopoly limits output and keeps price high.

A monopoly redistributes income from all the consumers to this one firm or
person (an equity issue).

Monopolists may develop political and social power over others, which reduces
the efficiency of democracy and is inequitable. There are political dangers of a
few very rich and powerful people (Marx called them “monopoly capitalists”
who misuse their position and exploit people).

A monopoly may behave badly in an anti-social way. For instance it may force
out a rival firm by selling its product at give-away prices, well below cost and
taking the short term loss. After it has forced out the competitor, it will then put
the price back up again. This behaviour may or may not be legal. It depends on
the country involved and its legislation but it is always reprehensible.

The lack of competition tends to promote inefficiency, the company rests on

laurels, there is no need to try hard, and it lacks dynamism. This is probably the
main criticism – said Austin Robinson

The result is lazy managers and owners.

This means that technical progress is reduced, leading to slow economic growth
of the country and a lower standard of living than we could have.

Resources are misallocated. Too many go to the monopolist and they are not
fully used by him. This is a waste for society and in addition, the price
mechanism is prevented from working properly.

A monopoly reduces consumer choice. There is no one else to buy from and no
other producer’s product.

A monopolist may ignore small market demands as he cannot be bothered to

meet them. You will recall that I mentioned earlier that Henry Ford is supposed
to have said about his motor cars “You can have any colour you want, as long
as it’s black”.

The long run effect from the existence of monopolies is slightly slower growth;
a lower standard of living; higher unemployment (because the monopolist
restricts output and so requires fewer people); higher prices (which monopolies
charge); a slightly poorer balance of payments as a result of this; a less equal
income distribution; and poorer resource allocation.

Benefits of monopoly – there are not many really, but some case can be made.

A monopolist can use monopoly profits for research and development, leading
to product improvement, faster growth, and lower costs, despite the argument
above that they are inherently lazy.

- Joseph Schumpeter argued that they are important for innovation; he felt
that big firms are the only ones that are able to afford the necessary
laboratories, equipment and research staff.

- Against this, research exists that shows many of the breakthroughs come
from small firms, for example Apple began making those computers in a

Monopolists may be able to reap economies of scale, for example the Royal
Mail; the provision of telephone lines; the supply of electricity; the supply of
gas; and the provision of railways. Economies of scale mean lower costs
(although the monopolist Royal Mail is notoriously inefficient in the new

A state monopoly may be safer than a private one. A private monopoly may be
more tempted to cut corners and reduces necessary maintenance to lower costs,
and this could be particularly serious in some areas like the railways or air
traffic control.

A reminder: are you revising something and practicing drawing diagrams each


(The bit in the middle!)

What is monopolistic competition?

It is defined as a situation where there are:

Many buyers and sellers of that type of good or service (= “competition”).

Free entry and exit (= “competition”).
But each with its own brand of the good or service (= “monopoly” on the brand
So each faces a downward sloping demand curve for its branded product (= a
monopoly on the brand name).

Notice the mixed elements of both monopoly and competition, hence the name
“monopolistic competition”. You know it makes sense!

Where is the long-run equilibrium position?

At the tangent of the demand curve and the average cost curve, as in the diagram



0 Q1

Q. Why is equilibrium tangential?

A. Because of the assumptions of strong competition.

If the firm improves the product, e.g. suddenly changes the colour to a currently
fashionable one, the demand for the product will increase from D1 to D2 in the
diagram below. This allows the price to increase to P2 and more units are sold (OQ2)
and hence higher profits are made in the firm.

Why is the new price at P2?

We read off the new equilibrium position from the intersection of the marginal
revenue curve (MR2), (which relates to the new demand curve D2) with the marginal
cost curve (MC). This intersection determines the quantity that it is most profitable to
produce, which is OQ2. Then we just go straight up and read the price the firm will
set from the new demand curve. Why from this curve? Because the demand curve is
the curve that relates price to quantity, you will remember, and we have just
determined the quantity.



D1 D2
0 Q1 Q2

The firm is then getting monopoly profits – and the equilibrium diagram to reveal
these is the same as the standard monopoly diagram. The profits are the area P A B
AC in the diagram below.

Price, Costs



0 Q Output

But these monopoly profits can occur in the short term only!

The higher profits and visibly higher price draw the attention of competitors who can
compete by colouring their product also!

The demand for the original product then falls back.

Q. How far does it fall?

A. Until the monopoly profits are eroded to zero when competitors stop coming in!

So in long run there can be no monopoly profits – the equilibrium position is always

NOTE the price in equilibrium: it is on the average cost curve but is above the
marginal cost curve. (Multiple choice questions might ask about this!)

Problems with monopolistic competition

There are wastes of time and effort – the firm will worry about the actions of

There are wastes of resources, for some are underused. You can see this because
where we are operating is not at the bottom of the average cost curve and excess
capacity exists.

There may be too much product differentiation; the firm may pretend its product
is “better” but it may merely be different.

There are the wastes of advertising.

There may be other promotional wastes, like free gifts, 2-for-1 offers, or
competitions to get a trip to Spain etc. instead of lower prices or better quality.
Running such schemes does use real resources.

The benefits of monopolistic competition

It is very competitive – the firms watch their competitors very closely.

This competition drives firms along and there is strong endeavour to improve
quality and design, as well as to lower price.

Free entry and exit keeps the level of competition up.

Variety is great, there is more choice and hence, we assume, greater consumer
satisfaction. Some however argue that there may be too much choice which can
confuse and irritate people rather than help them.

On balance, there is a lot of monopolistic competition in the real world; some argue it
is the mainspring that drives the economy forward by producing new goods, cheaper
goods, better goods - or at least different ones.


There is some overlap with Unit 2 about efficiency, so some of this you may already

The types of efficiency in economics:

a) Allocative efficiency.
b) Productive efficiency.

This concept of efficiency is static. Static efficiency looks at given resources and tries
to get the most output from them – and all firms should sell at a fair price to
consumers, which would reflect the real resources used.

A. Allocative efficiency

This occurs when the value the consumer puts on a good or services is identical with
the cost of resources used in producing it. This happens when price = marginal cost.
In this situation, total economic welfare is maximised.

Price, Costs



0 Q

At A, with P2 and Q2, MC = P we have allocative efficiency.

In the perfect competition diagram below, where MC = MR for the firm, we have
allocative efficiency because firms marginal revenue is the price, so MC = P.

Price, Costs


0 Q

The consumer surplus and the producer surplus

You will recall these concepts which were introduced in Unit 1. If you have forgotten,
go back and look it up now, before reading on.

Price, cost,
revenue Supply curve under
perfect competition

P pc producer

0 Q pc Quantity

Here we are in perfect competition with price “P pc” and quantity “Q pc”.

There is allocative efficiency in a perfectly competitive industry and price equals

marginal cost.

Note that the whole of the area between the supply curve and the demand curve is
taken up by the consumer surplus and the producer surplus.

This is not the case in the monopoly diagram below. In contrast, in that diagram that
area is not all taken up by the two surpluses. You can see the triangle of “dead weight
loss” that goes neither to consumer surplus or producer surplus and so is lost to

society! We do not have allocative efficiency (where MC=MR) because the
monopolist limits output and sells at a higher price in order to maximise profits.

Price &

consumer loss triangle

0 Q Quantity

The deadweight welfare loss under monopoly is the small triangle as indicated.

B. Productive efficiency

This kind of productivity exists when we are on the production frontier; this means we
are using the least resources possible to produce any given output. This also means
that we are at the minimum point on the AC curve.

This happens when we are in perfect competition – so economists prefer this state and
may refer to as it “X-efficiency” – it is where we are truly efficient.

Where market equilibrium is efficient, we cannot make someone better off without
making someone else worse off (this is sometimes called “the Pareto optimum

Note that we can have allocative and productive efficiency but still have inequity. As
an example, if you as an individual have all the income in the suburb in which you
live, the other people living there will be poor and might even starve! The market
system is amoral i.e., it is not concerned with good or bad.

Social efficiency matter too!

We might produce too much or too little for our own good as a society, even if have
perfect competition and an acceptable distribution of income. This can happen
because of the existence of externalities. The state might intervene and try to
encourage all positive externalities and reduce the negative ones.

Recall the discussion in Unit 2 about externalities, social costs, and private costs. If
you are less than certain about these, now would be a good time to go back and revise
that part of the course.

Here as a reminder are the two diagrams involved.

Negative externalities cause the social cost curve to be above the private cost curve.

Social Costs,
Social costs

Pb Private costs
(Social Marginal Benefit)
0 Qb Qa

Positive externalities (usually harder to find) cause the social cost curve to be below
the private one.

Social Costs,
Private costs

Pa Social costs
(Social Marginal Benefit)
0 Qa Qb


Definition: price discrimination is the charging of different prices to consumers for

the same good or service in order to increase profits.

1. First degree price discrimination:

This means that a firm can charge each consumer the maximum s/he would be willing
to pay. If perfect price discrimination occurs, it means that the entire consumer
surplus is extracted by the producer, and so it falls to zero.

If we think of the demand curve and price starting to fall price in blocks of one unit –
Q1 and P1, the producer can extract the area above equilibrium, which, say, is at P3.


Q1 Q2 Q3 Q4
0 Quantity

Many companies that supply homes with electricity use this method– the first block of
units is expensive, then the units get cheaper as the family uses more electricity over
the month. Check your electricity bill at home and see if it is happening to you!

2. Second degree price discrimination:

This occurs when a firm sells at its profit maximising position, and finds it has some
goods/services left over, so it sells this surplus more cheaply to others.

This is commonly done with airline seats and hotel rooms – have you heard of Look it up on the internet – there are bargains to be had! You might
also encounter cheaper cinema seats on one day of the week, or perhaps in the
afternoon but not the evening.

Where second degree price discrimination exists, fixed costs typically are large, and
marginal costs are low or perhaps virtually constant.




0 Q1 Quantity

Here the firm first produces where MC = MR (at Q1 and sells at P1). Marginal costs
are constant – think of empty airline seats where the marginal cost is tiny; it is the cost
of one more meal and a miniscule extra amount of fuel.

The company can increase its profits further by selling the first quantity at the high
price OP1, then expanding its output to Q2 and selling the remainder for price OP2.
The computer programs the airlines use are sophisticated, and can offer seats at
different prices, starting a bit below P1 and reducing all the way to P2, to earn more
money. On any full commercial airline, the passengers are normally paying a whole
variety of prices for this reason.

3. Third degree price discrimination:

This is often called “the price discriminating monopolist”.

This happens where a monopolist can sell at different prices in different markets.

To occur at all, it requires three things:

There is a monopolist.
The markets can be kept separate.
There are different elasticities of demand in each market.

The consumers in the market with the most inelastic demand always face a higher

We locate the marginal cost in the usual way, from the monopoly diagram. We then
apply that MC to both the separate markets. Because each separate market has a
different demand curve and elasticity, they have different marginal revenue curves.
Putting this another way, once we know the actual MC figure, we can trace it across

to both markets, see the intersection with the MR curve in each, and set the price in
each. This will be different in each market because the elasticities are different.

We determine the overall MC=MR position on the left hand side of the diagram
below. Then once we have the MC point established, we read this MC across to
where it cuts the individual MR curves in the first two diagrams. That point
determines the price in each market, reading up off the demand curve in those
separate markets.

Price, Price, Price,

costs costs costs



AR Established
0 Q MR 0 Qa MR 0 Qb MR

Total Markets Market A Market B


The market with the relatively inelastic demand always has the higher price. This is
expected as the greater the inelasticity, the more people want to buy it and are
prepared to pay that much more for it.

This situation of different elasticities is typical of foreign markets and home markets.
In the world in which we live, for most goods and services the demand in the global
market is more elastic than in each domestic market. This is because competition is
greater at the global level - the whole world competes! Therefore, firms that export
often charge more in the home market (where the elasticity of demand is lower) than

Any multiple choice question or data response question about different prices in
different markets will be about the first, second or third degree discrimination
possibilities. You just have to think about it and decide which one it is, unless the
question makes it clear upfront.


Pricing strategy and promotions

These never exist with perfect competition – as all firms are price takers! There is
no need to advertise one’s own product as the tiny firm can sell all that it can
produce at the same market price.
Under monopoly there is some need to advertise to keep the product name alive;
some of the ads might be of the “Our Company is really nice” type which you will
see on TV now and then.
Oligopolistic firms very commonly advertise because they have a competitive
structure and a downward sloping demand curve. They have constantly to
compete with their rivals.
With monopolistic competition there is also a lot of advertising, again because of
the very competitive structure and the downward sloping demand curve for their

Collusion and cartels.

[Covered already].

Cost-plus pricing

The price is set as the average cost of item + a percentage mark-up.

Predatory pricing

This is when a firm deliberately makes a loss by charging a low price in the short term
in order to drive out rivals or new entrants; in the long term this means higher profits
for the firm as it can enjoy a higher price. It also means an easier life with fewer
worries about the actions or reactions of rivals.

Limit pricing

This can be a feature of oligopoly: the firms may try to prevent new entrants by
agreeing on a price that they will all charge. It will ensure that they all make good
profits but not maximum profits. The price and profits are not quite high enough to
attract other firms to the industry but will be above those set in perfect competition.

Advertising and sales promotion policies

Advertising is designed to move the demand curve outward and to the right. It may
also serve to make the demand curve for the firm’s product less elastic when
compared with competitors’ curves. This means a higher price can be charged and
more revenue and profits gained.

Non-price competition

One often sees this with supermarkets. It may include:

Special promotions. These may take the form of competitions where one has to
send in two or more box tops to enter; or special offers like 2 for 1 – a form of
price competition that can stopped and started easily without changing any printed
advertising material.
Home delivery.
Store loyalty cards (which also track what each customer buys and how often,
which is most useful information for the store).
Extended opening hours, including Sundays and holidays.
Selling petrol on the forecourt.
Services such as a chemist being available, dry-cleaning, or photo-printing.
Internet shopping facilities.

“Contestable markets”

This occurs where we have a monopoly or oligopoly, but that has few or no barriers
to entry and exit. This can force the firm(s) to keep price reasonably low and
competitive in order to prevent others entering. So although it may be a monopolist it
does not actually behave like a monopolist and therefore does not enjoy high
monopoly profits.

William Baumol invented the model. He saw such firms producing at the bottom of
their average cost curve. They have to be efficient or other firms would enter.

For policy purposes, it means it may be better to consider reducing the barriers to
entry and exit rather than focussing on the degree of competition or market
concentration ratios as we usually do.

Barriers to entry include:

High sunk costs (fixed costs).

Whether a firm can lease equipment or not. If it is possible to lease, then a new
firm can enter or an existing one leave easily, because it does not have to buy or
sell the aeroplane or whatever is necessary.
Advertising and brand recognition. It is harder to break into an industry if there is
a well-known product already dominating it.
The existence of over-capacity which was deliberately built so that the existing
firm can flood the market quickly with more products at lower prices, if a new
entrant tries to get in.
Predatory pricing. The simple undercutting of the newcomer until he goes


This was developed to show what happens in a situation where when one firm makes
a decision, it has to consider the possible reactions of others to that decision.

Game theory is particularly useful in the oligopoly area where the reactions of others
are central.

“The Prisoner’s Dilemma” is a nice model which shows that competition can
sometimes be bad, but cooperation can be good. Here is an example.

Two men, Arnold and Brian (i.e., A and B), are arrested for robbery with violence and
interrogated separately.

The police say to each that we are certain that we can get a conviction, but:

If neither of you confesses each will be charged with robbery and will definitely
get twelve months in jail.
If you both confess then you will each get eighteen months.
But if you alone confess, you will be let off with a caution but the other will get
three years in jail. Now, can you trust your friend? If he confesses and you don’t,
you will be eating a lot of porridge. Why not confess now?

A problem!

It is tempting for Arnold to confess and hope that the other doesn’t! Then A gets
let off scot-free.
But if both confess, Arnold knows he will get eighteen months!
If he refuses to confess, he will get twelve months in jail if the other keeps quiet –
but he will get three years jail if the other confesses!

Clearly both are better off if neither confesses (eighteen months each).
But for either alone the “dominant strategy” (roughly the best bet) is to confess
(because he gets let off free if other does not confess).
However, if he does not confess but the other does it means the full three years!
So each is really pressured to confess even although it is better for both the
accused if neither does!

What can we learn from the Prisoner’s Dilemma?

Collusion would solve the problem! If the two involved could discuss it and agree,
neither would confess! Both would gain the most that way.

And collusion is common in oligopoly!

Price wars with oligopoly:

If there are two firms, it is best if neither starts a price war – if they co-operate and
keep the price high, that is as good as it gets.

Let’s think of an example. Assume that currently each sells 10 units at £4 each, so
total revenue is £40 for each firm or £80 in total. But if firm A cuts his price to £3 he
hopes to sell, say, 17 units at £3 and his total revenue would then be £51, a distinct
improvement. The other would of course be able to sell fewer items. Possibly he
might be able to sell 4 units or so at the unchanged price of £4, so that his total
revenue would be $12 with much reduced profits.

The total revenue of both together is $51 + $ 12 = $63 (and remember it was
previously $80!) As a pair they are losing out, even if one does better.

Then B might respond: it is tempting for B to cut his price perhaps to £2.50 and hope
to sell a lot more.

This process might continue with both firms cutting prices in turn, and both losing out
even more. Game theory suggests they would be better off to collude and go back to
the original situation of a price of $4 each and total revenues of $80 for the two, or
$40 each!

The concept was invented to describe the observed stickiness in prices under oligopoly, i.e., to answer the
question “Under oligopoly, why do prices alter infrequently?”

The theory was developed that when an oligopolist had already set a price, he was reluctant to change it.
He felt that if he increased his price, he would lose business to his rivals and competitors (who would
make no changes in their price) and so profits would fall. However, he felt that if he lowered price to in-
crease his sales, his competitors would follow suit, reducing their prices also, so he would not be any bet-
ter off. Indeed selling at a lower price, his profits would fall. So if a price rise or a price reduction could
easily reduce his profits, he would do neither. Hence the price would remain unchanged for long periods.

If we put this in graphical form, we can see that we start at his current price, chosen randomly in the dia-
gram, and look at what he expects to happen if he alters his price.

1. He feels that a price increase would lower profits. This would happen if the good faces an elastic
demand. So above his existing price we see an elastic demand curve.
2. He feels that a price reduction would lower profits. This happens if the good faces an inelastic de-
mand. So below his existing price, we see an inelastic demand curve.

If we draw this, we observe the following.

Price, Costs

Elastic part: if increase price

D expects will lose sales to competitors

P Inelastic part: if reduce price

expects competitors will do the same
so he cannot gain

0 Q Output
The marginal revenue is the addition to profit from the marginal unit sold (commonly seen as the last unit
sold). As price is reduced, the marginal unit sells for less than the previous unit sold – indeed for less than
all the previous units sold. So the firm loses revenue from all the earlier units as well as the current one.
For this reason, marginal revenue is always below the demand curve but they both start together on the
very first unit sold. (When the first unit is sold at the price £X, the addition to total revenue is also £X).
The marginal revenue curve falls faster than price because of the loss on all the earlier units, once the
price of the marginal unit is reduced.

If we put in the marginal revenue curve and a couple of marginal revenue curves, we see the follow-

Price, Costs


0 Q Output

The maximum profit point is where the marginal cost equals marginal revenue. If we start with MC1 we
see the MC curve cuts the MR curve in the vertical part and price will be P (reading off the demand curve
– the curve that relates quantity to price).

If costs fall to MC2, the price remains the same, P, because we MC2 still cuts the vertical part of the MR
curve, so the optimum quantity and price is unchanged.

This means that price does not alter much, because if we move the marginal cost curve up or down from
wherever it is, it always cuts the marginal revenue curve in the vertical part on the kinked demand curve.

Hence we see sticky prices under conditions of oligopoly - according to the theory of the kinked demand

Criticisms of the Kinked Demand Curve

· It does not explain why the price is where it is! This is a major hole in the kinked demand curve as
a general theory as it only shows us why price does not alter much. In its defence, it was not de-
signed to be a general theory.

· In the real world, price changes seem more common than the kinked demand curve theory sug-
gests that it should be. Prices do alter!

· The theory may be more beloved of examiners (many of whom like setting it) than a realistic de-
scription of the world. After all, the firm can always try to increase or reduce price and see what happens!
If it gains, good; if it does not gain it can go back to the original price. This is an easy theory to test for
the firm so there is no reason to think the owner just sits there and worries that he would lose if he chang-
es his price.


What is it?
It is part of “the economics of regulation”. We are aware that some leading members in industry and
commerce, left to their own devices, are likely to behave in ways of which society disapproves. In the
absence of regulation and inspection, some members will engage in price fixing and collusion, bribery of
government officials, lie to customers, break various laws, such as dumping waste produce in National
Parks, and the like.

What does society do to try to protect itself and the general public?
The government frequently establishes one or more regulatory bodies to oversee the industry and try to
control it, in order to protect society as a whole.

What often happens?

The body in charge gets taken over by various vested interests until the regulatory body eventually starts
to work for the vested interests and ceases to protect society. In other words, there has been “Regulatory
capture”. In a less extreme form, the regulatory body may not be entirely taken over, but a cosy relation-
ship between the body and the industry tends to build up over time so the policing powers become weak.
There is always the risk of total capture but many economists feel that this extreme position is perhaps
not all that common.

How can the body be influenced or captured in this way?

· The industry is likely to have a lot more money than the government body and so can hire more
and better staff.
· The regulatory body frequently consists of members who have several jobs or advisory positions,
and can devote only limited time to the work of the body. The industry, by contrast, can employ
full-time workers to try to present a better case and improve the position of the industry.
· The industry can pay for “research” that demonstrates what a good bunch they are and how well
they behave.
· The industry can lobby individual Members of Parliament (and offer inducements for support,
some of them not entirely legal).
· The industry can plant articles in newspapers and elsewhere that support their case.
· The appointments to the regulatory body are often top civil servants who know and have worked
with leading members of the industry and so have already developed a friendly relationship.
· It has been alleged (NB I suggest you ALWAYS put in this phrase when you are writing about the
issue in public; it can protect you from being sued by powerful people!) the UK government’s
Medicines and Healthcare Products Regulatory Agency is effectively promoting the pharmaceuti-
cal industry in its efforts to sell drugs and increase profits, rather than protecting the public and
helping to keep down the drugs bill of the National Health Service..

· It has been alleged that the Food Standards Agency does not work hard to stamp out additives to
foods that might be dangerous to children, including some that promote hyper-activity and poor
learning. It is suggested that the Agency tends to pass the buck to the equivalent European body,
as well as to the parents of the children, rather than act to improve things themselves.

What might be done to improve the situation and break the cosy relationship between a regulatory
agency and the people it is supposed to police?
It might be possible to:
· Insist that all appointees to a regulatory body are approved by, say, a Parliamentary committee.
· Not to allow top civil servants to leave and join the industry (e.g., when they retire) until, say, 4
years have elapsed.
· Regularly change the members of the regulatory body, to prevent cosy relationships developing.
· Not allow inspections of companies in the industry by single inspectors but insist on at least two,
in order to make offers of bribes or other inducements more difficult.
· Rotate the teams of inspectors, so that on each visit the industry has to deal with new people.
· Protect whistle blowers – people who reveal what is actually going on. Experience suggests that
whistle blowers regularly do badly once they have revealed an unpalatable truth; they are infre-
quently promoted; they are often given poor references should they leave; and their names might
even appear on secret blacklists.

Names associated – you can quote the names in exam answers

· Adam Smith in the Wealth of Nations was the first to point out that when business people meet up
they tend to collude to raise prices.
· Richard Posner, at the University of Chicago, is a main name in the regulatory capture debate. He
argued that regulation is not really about serving the public interest (although it should be) but the
process actually serves the interests of many, all of whom seek to promote their private interests.

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