A-level Economics/AQA/Markets and Market failure

What is Economics?
Economics is the study of the social relations of production and distribution and how different
societies cope with the basic economic problem of scarcity. It is also the study of human behavior as
it makes rational decisions to satisfy its needs.
and also, "Economics is a social science that studies human behaviour as a relationship between
ends and scarce means that have alternative uses" (Robbins)
[edit]Scarcity
Scarcity is based on the premise that human beings have unlimited wants and needs and that the
resources which can be used to fulfill these wants and needs are limited (or finite). This means that
choices have to be made about what, how and for whom to produce goods or services. Given the
fundamental problem of resource scarcity in the face of infinite human wants, economic agents must
make choices between competing alternatives. If resources were not scarce, there would be no
need to choose between competing alternatives. Economics for this reason is also referred to as the
science of constrained choice. Scarcity is why efficiency is so important to economists as inefficient
use of resources reduces the amount of wants which can be satisfied.
[edit]Factors of Production
Economic resources can be divided into four different categories; LAND, LABOUR and CAPITAL
and ENTERPRISE. These are referred to as the factors of production, each of which has a factor
payment.
Factor payments are payments made to scarce resources, or generated by the factors of production,
in return for productive services. The factors of production are also known as resource inputs to the
productive process.
[edit]Land
Land consists of all naturally occurring resources, i.e. agricultural land, mineral deposits. The
resource land includes anything growing on land such as forestry or agricultural produce, or
mineral subsoil assets lying beneath the surface. The factor land thus generates many different
types of raw materials used in the production process.
The factor payment for land is RENT.
[edit]Labour
Labour is a measure of the work carried out by human beings
Supply of labour is initially determined by the total population but then more directly by the
labour force (those who are of working age and who participate in the Labour force).
The skills and training of the labour force affects the overall PRODUCTIVITY.
The factor payment for labour is WAGES
[edit]Capital
Is the physical and non-human inputs used in production. This can can include factory buildings
and other equipment such as vehicles, plant and machinery or tools used in the production
process.
The factor payment for capital is INTEREST. Interest is a simplification which embeds the
assumption that typically many firms use a mixture of equity and debt to fund to acquisition of
capital. Interest is payable on debt used for capital acquisition or expansion.
[edit]Enterprise
Enterprise is the role of entrepreneur within the economy. The entrepreneurial ability of
management organises the other three factors into a cohesive production process which results
in the output of goods or services.Enterprise represents the skill of management.
The entrepreneur is the risk taker who combines the other factors of production to create a good
or service for which there is demand.
There are several factors which can affect the level of entrepreneurship within an economy
Start-up costs - high start-up costs will discourage entrepreneurship as it reduces the level
of profit which can be attained. High start-up costs also discourage entrepreneurship
because the total loss is great if the business fails.
Level of profits - the higher the level of profit available the more incentive for the
entrepreneur, this can be altered by wages levels and availability of labour, availability and
cost of land, level of tax on profit
Support - Financial support, such as loans. Knowledge support, advice on things such as
marketing or accounts can encourage entrepreneurs.
Factor payment for enterprise is PROFITS. Profit is also the return to the firm and its owners
after all other factor payments have been made. Dividends represent a distribution of profits.
[edit]Markets
A market is anywhere where buyers and sellers meet for purpose of exchange, such as: eBay, a
market etc. Within a market prices are determined by the market mechanism.
[edit]Supply and Demand
[edit]Demand
Demand is the amount of goods and services buyers are willing and able to purchase at a
given price over a given period of time, Demand can be represented graphically in a demand curve
or in a table known as a demand schedule. The main determinants of demand are; the price of the
good, the price of substitute goods, the price of complimentary goods, levels of income. The price
of a good and the quantity demanded usually have an inverse relationship; if one
increase the other decreases.
[edit]Demand Schedule
Demand schedules are tables which show the price of a good and the quantity demanded.
An Example Demand Schedule
Price () Quantity Demanded ( 000's )
40 500
50 450
60 400
70 350
80 300
====Demand Curve==== A demand curve is the graphical representation of a demand schedule, in
which quantity demanded is plotted on the X axis and price on the Y axis. The curve on a demand
curve slopes downwards left to right, the only exception being status goods in which the demand
curve slopes upwards from left to right.
[edit]Movement Along a Demand Curve
Movement along a demand curve occurs when the only variable to change is the price. For goods
(except status goods) an increase in price causes a contraction of demand and a decrease causing
an expansion of demand. In this example the
original price of the good was at P1 and the quantity demanded was at Q1. An increase in price to a
level of P2 has caused a contraction of demand to a level of Q2.
[edit]Shifts in Demand Curves
A shift in a demand curve occurs when a variable other than price changes. For instance a change
of income, a change in fashions or trends, a change in the price of a complimentary or substitute
good, a successful/unsuccessful advertising campaign.
[edit]Price Elasticities of Demand
The extent to which the quantity demanded responds to a change in price.
Price elasticity of Demand =
Which can be worked out by; Price elasticity of Demand
=
[edit]Types of Price Elasticity of Demand
Perfectly Inelastic Demand
P.E.D = 0 Any change in price will have no change in demand and whatever the price is the demand
will remain equal. If this were to occur firms would set as high a price as possible to make maximum
profit.
Inelastic Demand
0 < P.E.D < 1 This means that any change in price will have a less than proportional change in
demand.
Unitary Demand
P.E.D = 1 Any change in price has an exactly proportional change in demand, i.e. 10% reduction in
demand would cause a 10% reduction in price.
Elastic Demand
1 < P.E.D < Any change in price will cause a greater than proportional change in demand.
Perfectly Elastic Demand
P.E.D = Any change in price will have an absolute change in demand as buyers will only buy at
one price and no other.
[edit]Supply
The quantity of goods and services a firm is willing and able to sell at a given price over a given
period of time.
[edit]Supply Schedule
As with demand schedules supply schedules are tables which displays the amount of goods and
services supplied at what price.
An Example Supply Schedule
Price () Quantity Supplied ( 000's )
40 500
50 550
60 600
70 650
80 700
[edit]Supply Curve
A supply curve is the graphical representation of a supply schedule, in which quantity supplied is
plotted on the X axis and price on the Y axis. The curve of a supply curve slopes upwards right to
left, the only exception being status goods in which the demand curve slopes downwards from right
to left.
[edit]Equilibrium
Equilibrium is the point in a market at which supply and demand intersect, thus giving the
equilibrium price and quantity. In the example below the equilibrium price is P1 and the
equilibrium quantity is Q1. Were the price or the quantity supplied to change then the market would
be in a state of disequilibrium. A price above P1 would mean there would be an excess of supplies,
and a price below P1 would mean there is excess
demand.
[edit]Elasticities
Elasticities measure the change on one variable in proportion to another.
[edit]Income elasticity of demand
Income elasticity of demand is a measure of the responsiveness of the demand for a good or service
to a change in income. If an increase in income lead to an increase in demand, then the income
elasticity of that good or service would be said to be positive. If a change in income lead to no
change in demand then that good would be said to have an income elasticity of demand of zero. A
rise in income leading to a decrease in demand would mean that the good or service is said to have
a negative income elasticity of demand.
The following formula is used to calculate a good or service's income elasticity of demand: Income
elasticity of Demand =
[edit]Cross elasticity of demand
Cross elasticity of demand measures the responsiveness of the demand of one good to a change in
the price of another good. This allows, for instance, how a rise in the price of natural gas affects the
demand of electricity. In addition to this, by calculating the cross elasticity of demand, it is possible to
identify the relationship between two goods or services. If the cross elasticity of demand for two
goods is positive, then it can be summarised that the two goods are substitute goods, as would be
the case for the example of natural gas and electricity. If the cross elasticity of demand for two goods
is negative, then the two goods are complimentary goods, such as fish and chips.
The following formula is used to calculate the cross elasticity of demand:
Cross elasticity of Demand
=
[edit]Price elasticity of supply
Price elasticity of supply is a measure of the responsiveness in quantity supplied to a change in
price. The following formula is used to calculate price elasticity of supply:
Price elasticity of Supply =
[edit]Factors Affecting Elasticity of Supply
1.Stock low stock-supply inelastic large stock-supply elastic
2.Time short period-inelastic long period-elastic
3.Availability of substitutes easily replicable capital and labour-elastic
4.Spare capacity less-inelastic more-elastic
[edit]Monopoly and The Allocation of Resources
An absolute monopoly is a market structure in which only one firm supplies a good or service. In
addition to this there are, within the UK, legal monopolies, which are firms with a market share
greater than 25%. In the long run, monopolies are created and prosper due to the erection of
barriers to entry.
'Legal Barriers' The law can be used to create monopolies. This can be achieved in a number of
ways. The use of copyrights or patents are examples of a legal barriers to entry. As one firm controls
the production of goods for which they have a patent or copyright they can become monopolies. A
further example would be the granting of a permit by the government to a firm, such as, the
numerous train companies which are monopolies for their respective lines, allowing only them to run
trains. Professional licensing is also promoted by existing firms in an effort to keep out additional
firms. The licensing laws are often set up in ways that favor existing firms, but are difficult for new
firms to meet.
'Resource Barriers' If a firm is able to control some or all of the resources necessary to produce a
good, it can then become a monopoly. For instance, an oil company which controls all the oil fields
has monopoly power over the production of oil. De Beers, the diamond company, controls over 95%
of the Earth's diamond reserves, allowing only a certain number of diamonds to be mined a year,
keeping the price high.
'Unfair Competition' Firms may undertake acts of unfair competition to maintain their monopoly
status or to become monopolies. If a large firm is in competition with another then it could, as an
example, lower its prices to a level which would drive a competitor out of business, safe in the
knowledge that the loses associated can be sustained for a short amount of time due to the large
reserves of the firm. Having driven the competing firm out of the market the monopoly is then free to
revert back to the previous price charged.
'Natural Cost Advantages' Due to economies of scale (in which a larger firm can make a product at
a lower per-unit cost than smaller firms due to the larger scale of its production capacities) and
economies of scope (in which a single large firm can use the same input resource in multiple
production processes, resulting in the production of multiple goods for lower per-unit costs than two
smaller firms would experience), it is possible that a market with a single large firm is the most cost-
efficient means of producing a good or service.






















A-level Economics/AQA/Business Economics and the
Distribution of Income

Theory of the Firm
The theory of the firm is a series of economic models utilised to understand and explain the nature of
firms and their interaction with the market.
[edit]Costs
One such economic model is that of the costs which a firm faces. There are two main types of costs
discussed; fixed and variable costs.Fixed costs are costs which remain constant at all levels of
output. Variable costs are those costs which vary with the level of output. Marginal cost is the cost
of producing an extra unit of output. Average cost is the average cost of each unit of output for a
given level of output. Total cost is the sum total of costs for a firm at a given level of output.
[edit]Calculating and Graphing Costs
In addition to being able to define the different types of costs facing firms it also required that you are
able to interpret cost curves and calculate costs. Below is a table illustrating the total, average and
marginal costs of a fictional firm.
Output
Total
Cost
Average
Cost
Marginal
Cost
1 100 100 100
2 110 55 10
3 150 50 40
4 180 45 30
As is demonstrated by the table the formula for calculating the average costs of firm
is:
The marginal cost is the extra cost incurred by producing an additional unit of output, therefore, to
calculate it the total cost of production at the current level of output is subtracted from the total cost
of output at the previous level of output.
[edit]Revenue
There are also equivalent revenues for each of the costs. Average revenue is the average amount of
revenue from the sale of a given number of units. Marginal revenue is the additional revenue
generated from the sale of an extra unit. Total revenue is the total revenue generated from the sale
of a given number of units at a given level of output.
[edit]Objectives of the Firm
There are a number of possible objectives which a firm may aspire to. This may be to maximise
profits or to maximise sales. Newspaper editors may want to maximise their readership and will
therefore endeavour to produce at the lowest average cost possible in order to achieve the lowest
price and the highest level of demand. A firm seeking to maximise profits on the other hand will
produce at a level where the marginal cost and the marginal revenue intersect.
[edit]Models of Market Structure
Economists have developed and utilised a series of models of different market structures to explain
the different behaviour of firms in markets with different structures. As a model by definition is an
attempt to simplify a complicated behaviour each model is based upon a series of assumptions and
is therefore of limited use based on the validity of these assumptions.
[edit]Perfect Competition

Figure 1 - A perfectly competitive firm making normal profits
One such model is that of perfect competition. This model attempts to create a situation in which the
level of competition leads to both allocative and productive efficiency. It is based on the following
assumptions;
There are many firms all of whom produce the same quantity of goods or services and all of
whom have perfect knowledge of the other firms within the industry.
There are many buyers all of whom posses perfect knowledge of the industry.
The goods or services produced by the firms are homogeneous and not differentiated by
branding or marketing.
Firms have absolute freedom to enter and exit the market due to a total lack of barriers to entry.
These four assumptions lead to a further salient characteristic of the model which means that both
the consumers and producers are price takers as no single actor has sufficient market power to
influence the price level within the industry. In addition to this any firm within the market who will
accept the market price is able to sell all of its output, leading to perfectly competitive firms being
faced with a perfectly elastic demand curve as shown in figure 1. As it is perfectly elastic both the
marginal and average revenue remain constant.
[edit]Perfect Competition In The Short and Long Run
The short run is defined as any period of time in which there is at least one fixed factor of
production (i.e. land, labour, enterprise, capital). In the long run, however, all factors of production
are variable, meaning that firms can achieve different levels of profit in the short and long run. In the
long run it is only possible for a firm to make a normal profit. As all the products produced by the
firms in this industry are homogeneous and there are a large number of firms, an increase in the
price of one firms goods will lead consumers to switch to a competitor firm's product leading to the
firm with the higher price making a loss and eventually going out of business. A firm may, in the
short run, take advantage of a new production technique to increase output and therefore reduce the
average cost and price of a unit and make a short run abnormal profit (a profit higher than normal
profit). In the long run, however, as all firms have perfect knowledge regarding other firms within the
industry all firms will copy this new production technique and too lower their average costs and price.
[edit]Monopoly
A monopolist is a sole firm in an industry. A monopoly market structure is essentially the opposite to
the market structure of perfect competition. There must be high barriers to entry for a firm to stay as
a monopoly.
The following barriers to entry may exist:
Natural cost advantages
Legal barriers such as patents
Marketing barriers
Unfair practices


































A-level Economics/OCR/Introduction to economics-
Whats the problem

What is the problem?
Economics is the study of how to allocate or use resources such as money, land, etc. most
efficiently. The world is such that everything is scarce. Money is limited, food is limited, labor is
limited, steel and plastic are limited. Everything is limited and thus to do something we need to make
sure that resources are allocated in the best and the most efficient way.
Opportunity cost?
One problem here is that of opportunity cost. It is the "next best alternative that has been forgone"
while undertaking something. An example is that a person eats ice cream, the next best alternative
was eating a burger, which was not undertaken, thus the cost of eating an ice cream is eating
burger. This cost exists because the person has a limited amount of money and only one thing can
be bought. Companies and governments have to look at opportunity costs as well as time and
money when making decisions.
Scare resources?? What are the scarce resources then?? In economics they are:
Entrepreneur (defined in economics as anyone who takes a risk)
Land (your land on which you built a plant, office or mine etc.)
Labour (employees, skilled and unskilled labour)
Capital (this includes money, machinery etc.)
Increasingly another factor is added i.e.
Technology or knowledge (this helps a firm to improve productivity, efficiency, quality, etc. and
includes machinery, processes, training etc.)








A-level Economics/OCR/2885

Transport, Trends and the Economy
[edit]Transport
[edit]Measuring Transport Output
people/passenger transport - passenger-kilometres (number of passengers \times distance
travelled in kilometres)
goods/freight transport - tonne-kilometres (weight in tonnes \times distance travelled in
kilometres)
[edit]Characteristics of Transport
Transport is a unique product
Demand for transport is largely derived.
As a service, it is perishable
Transport decisions recognise two key dimensions:
distance
time
Transport generates significant externalities not recognised in the price (Private Costs are not
equal to Social Costs) therefore market fails
Journeys are indivisible
Loading is the % capacity used on a journey
Peaking: Demand > Supply, leading to congestion
[edit]Transport Infrastructure
Two components:
Network
Terminals/Nodes
Infrastructure critical to economic success because it affects:
transport costs and prices \therefore choice of mode
patterns of land use
operation of labour markets
location of business activity
Can deliver:
improved labour mobility\therefore greater efficiency
positive externalities through regional development
improved competitiveness
In addition:
Built up over time through investment:
replacement investment (maintenance)
net investment (additional capacity)
Under-investment since the war leading to relatively poor quality infrastructure
Investment:
significant lead times (5-30 years)
significant amounts of money (billions) from tax, borrowing and private funds
long payback (decades)
[edit]Transport Modes
Methods of moving goods and passengers
Often several mode options per situation:
Road
car, lorry, van, taxi, bus, coach, motorcycle, bicycle, walking
Rail
Air
Sea
Pipelines
Key issues in deciding between modes:
Relative cost
Distance
Speed
Bulk
Urgency (perishable goods)
Capacity
Convenience
Reliability
Network extent
Risk of delay/accident
Pollution
Traffic congestion
[edit]Demand for transport
Derived from economic activity
Changes in economic relationships lead to immediate changes in demand for transport
In UK, steady rise in demand
Increasing domination of road transport
[edit]Price and demand for travel
Travel can be priced and is demanded like any other product
The price of a journey includes the full cost to a passenger, expressed in (e.g. car: fuel, delay,
risk)
Demand expressed through:
number of passenger-kilometres
number of vehicles
Supply is fixed (inflexible service) Although there are more services in peak times of demand.
Demand varies hugely (e.g. 8:30am vs 3:00am)
Gross under-usage or peaking/congestion
Off-peak travel is price elastic
Peak travel is price inelastic
Low positive cross elasticity of demand
And your mum
[edit]Income and demand
Changes in:
Rates of economic growth
Business cycle
lead to large changes in demand for transport
Road, rail and air have a high YED and are sustainable
Buses have low YEDs, may even be inferior goods
[edit]Theories of market structure and competitive behaviour in
transport markets
[edit]Markets Overview
Emphasis is to:
understand theoretical models of markets (at A2 level)
explain, analyse and evaluate behaviour in transport industries and markets
In market (capitalist) economies:
Entrepreneurs/firms:
invest their own capital
take risks
hire/buy resources/factors of production
produce goods and services which they judge the consumers want in order to make at
least a normal level of profit
always make decisions with competition in mind
the nature/extent of competition can be defined in terms of the number and power of firms in
a market
a core factor which defines the power of firms in a market is barriers to entry/exit
where there are low barriers, profits tend to be normal
where there are high barriers, profits tend to be supernormal
With new entrants to a market:
the supply curve shifts right (an increase)
the price decreases
the quantity demanded expands
the consumer surplus increases
the producer surplus decreases
[edit]Perfect Competition
[edit]Characteristics
Infinite independent firms
Homogeneous product, so no advertising
Infinite buyers
Perfect information
No market power, so all firms are price-takers
No barriers to entry/exit
Perfect resource mobility
Firms are all profit-maximisers
Normal profits in LR, although losses or supernormal profits are still possible in SR
Theoretical model
Benchmark to assess all imperfectly competitive markets
e.g. window cleaners
[edit]Notes
Would deliver best economic outcome:
Allocative efficiency
products which consumers want the most
Productive efficiency
output at lowest AC
Yardstick to judge other markets/market structures
Framework for developing government policies in order to make markets more competitive
(e.g. transport)
[edit]Imperfect Competition
[edit]Characteristics
Imperfect competition displays at least one of the following to some extent:
Finite firms, allowing an individual firm to affect the market
Some market power, so all firms are price-makers
Differentiated products
Barriers to entry
Non-price competition
Supernormal profits in LR
[edit]Monopolistic Competition
[edit]Characteristics
Many firms (all independent)
Differentiated product
Price-makers to an extent
Downward-sloping demand curve
Many close substitutes
Relatively price elastic
No barriers to entry/exit
In LR, only normal profits
In SR, abnormal profits/losses can occur
[edit]Oligopoly
[edit]Characteristics
Few firms
Interdependant
actions take account of reactions
High degree of sales concentration - sales concentrated among a few firms
Firms are significant price-makers
Differentiated, branded products
Non-price competition - advertising/promotion to increase market share
Significant barriers to entry/exit
Abnormal profits in the LR possible - invested into advertising/R&D
[edit]Pricing Characteristics
Generally stable prices
Loathe to start a price war
Uncertain outcomes when changing price:
Prices cut:
Competitors follow suit
Volume gain insignificant (price inelastic)
Leads to a loss of revenue
Prices raised:
Competitors may not follow suit
Large decrease in volume (price elastic)
Leads to a loss of revenue

[edit]Collusive Oligopoly
Firms agree to act together to restrict competition on:
price
location allocation
Price is likely to be higher than the market clearing price meaning output/sales are likely to
be lower than they might otherwise be
May not maximise profits, in order to create a more secure environment
Most efficient firms will be tempted to break ranks by cutting prices, leading to increased
market share
Inherently unstable
Illegal
[edit]Monopoly
Either a single or dominant (>25\% market share) firm in the market
Insurmountable barriers to entry
Price-maker - they can set either output or price
Abnormal profits in the long run
Potential barriers to entry
High sunk costs
Some legal monopolies (e.g. TOCs)
Economies of scale
new firms cannot use EoS
Predatory pricing
Natural monopoly
best for consumer if there is a monopoly

[edit]Comparing perfect competition and monopoly
Perfect competition is productively and allocatively efficient
Monopolies are not
Monopolies are most appropriate where:
there is a natural monopoly
there are very significant economies of scale
abnormal profits are invested in R&D or to reduce costs
it would enable a domestic firm to compete internationally
[edit]Natural Monopoly
Occurs because:
One firm can operate more efficiently that two or more
There are high fixed costs \rightarrow significant EoS
More likely to be productively efficient
Minimum Efficient Scale leading to a high % of market volume/value
Cannot be threatened by more efficient new entrants
Regulation needed to protect captive consumers (e.g. railways)
[edit]Market Comparison Summary
Type of Number of Product Barriers to Abnormal Transport
competition firms differentiation entry/exit Profits Example
Perfect
Competition
Infinite None None Only in SR Taxi driver
Monopolistic
Competition
Finite Marginal None Only in SR Taxi firms
Oligopoly
Few, all
price-makers
Great High
Possible in
LR
TOCs, Airlines
Monopoly
One major
price-maker
None Insurmountable Yes
London
Underground
[edit]Contestable Markets
Recent government intervention:
Focus on increasing market competitiveness:
More customer-oriented, leading to better products
Greater efficiency, leading to lower costs
Lower prices
Profits
Three policy approaches:
Deregulation (e.g. buses, taxis)
Privatisation (e.g. rail)
Contestability
[edit]Barriers to entry
Can be technical or economic
Determine the degree of competition in a market
Lead to LR abnormal profits for monopolists
Transport examples:
British Rail - pre 1997 (legal monopoly)
Laker Skytrain - no-frills airline (predatory pricing)
Railways, cross-channel ferries (sunk costs)
Economies of scale
British Airways (branding)
[edit]Theory of contestable markets
The threat of entry leads to competitive behaviour:
make normal profits
productive efficiency
allocative efficiency
The number of firms is largely irrelevant
Contestable markets have:
one or few firms
minimal barriers to entry
minimal sunk costs
differentiated product
[edit]TOC franchise
Lump sum for franchise (contract)
Legal right to operate service for a limited period (initially 7 years, now 15 years)
Invest own money (which may not be returned upon within the time period)
Termination when period ends (loss of sunk costs)
[edit]Deregulation
Not appropriate for natural monopolies such as:
National Air Traffic Control
Network Rail
[edit]Bus Deregulation
Up to 1980:
Many companies nationalised in 1947
Licensing system
Local route monopolies
Price controls
Government subsidies
Cross subsidisation
Private hire coaches always privately owned.
1985/1980:
Price controls abolished
Prices reflected route costs
Social, non-profitable routes - out to tender
Offered (by local authority) to bid, requiring least subsidy
Limited subsidy funds
Licensing process abolished
Safety regulations remain
Any operator free to operate
Must notify Traffic Commissioner of closures/alterations of routes
Results:
Initial increase in competition
More entrants
More buses
More frequent services
Lower fares
Buses operated below capacity
More congestion and pollution
Prompted mergers and acquisitions:
Arriva
Stagecoach
Go-Ahead
First Group
National Express
Nationally, an oligopolistic market
Locally a monopolistic market
This leads to:
Higher fares
Lower levels of service
Withdrawal of most marginally commercial routes
Some small competitors operate with low margins
Large operators cannot entirely neglect the market
[edit]Air Transport Deregulation
Air travel has distinctive characteristics:
Significant externalities:
noise
climate change
diminished air quality
Short-haul particularly polluting
To internalise externalities:
Short haul: 3
Long haul: 20
Airports need land leading to urbanisation
Airspace and landing slots ('supply') limited
Capacity insufficient to accommodate projected demand
Operators:
Private (e.g. BA)
State-owned (e.g. Iberia)
Low-cost (e.g. easyJet)
Charter
Market segments:
1st class vs. economy/low-cost
Domestic vs. short-haul vs. long-haul
Business vs. leisure vs. holiday
Leisure is, for example, a long weekend whereas holiday is, for example, two weeks.
Infrastructure:
Airports
Air Traffic Control
Core regulation:
Flight worthiness
Air space security
Deregulation of air services:
USA: 1978
UK: 1987
Europe: 1993
Pre-deregulation:
Bilateral agreements between 'flag-carriers'
No competitive pressure
High fares
Post-deregulation:
Replication of US experience
Explosion of low-cost operators
'Flag-carriers' under immediate threat
EU "Open Skies Policy" under a common regulatory framework
50% new/unused slots allocated to market newcomers
Impact of deregulation:
Newcomers had a precarious existence
Rising profits for established low-cost operators
Premium carriers:
Losing passengers
Cutting prices
Experiencing falls in profit
Struggling to differentiate
Avoiding competition
Future:
Air travel has increased threefold since 1975
Freight increased twofold since 1990
UK economy depends increasingly on air transport:
Consumption
Investment
Tourism employment
Competitiveness
Airport demand, on current trends, will double by 2030
New capacity being constructed at:
Stansted
Birmingham
Heathrow
Edinburgh
[edit]Privatisation
Applied to buses and trains amongst others (e.g. utilities)
Operational decisions based on the needs of shareholders
More recently, two types of quasi-privatisation have been used:
[edit]Public Private Partnership
Partnership of public sector and private sector
Shared funding of a project
Shared revenues
e.g. London Underground:
Track, signals and stations are privately owned (for 30 years)
Operations stay in the public sector
[edit]Private Finance Initiative
Private company finances, builds and operates the infrastructure
Government pays fee for its use
State ownership in due course
Considered suitable for Air Traffic Control
[edit]Transport Infrastructure Ownership
Roads:
Quasi-public good
Largely non-rival
Partially non-excludable (to an extent)
Owned by the state
Funded from general taxation
Built/maintained by private sector, under tender
Rail:
Significant change since 1996
Network Rail:
not-for-profit private company
Railtrack plc replaced in 2002
Rail regulator (government body)
TOCs (private sector)
Air:
Airports and air service operators in the private sector
Air Traffic Control partially privatised (PFI to ensure adequate investment funds)
[edit]Rationale for privatisation
Profit incentive
No operational subsidies (money can be spent elsewhere)
Investment in latest technology
Introduce a business culture (competitive approach)
Operate more efficiently:
Lower LRAC
Lower prices
Be more customer-oriented leading to improved service
Significant source of funding, after decades of state neglect
More contestable market
[edit]Criticisms of privatisation
Assumes competitive environment in LR (e.g. buses)
Greater neglect of negative externalities
Reduced pay/conditions\rightarrow
demotivation
transfer of welfare to shareholders and consumers
Profit maximisation (investors want quick return)
Profit vs. performance vs. safety (conflicting stakeholder objectives)
Natural monopoly
Regulator needed to achieve economic efficiency
Private firms ignore equity issues
[edit]Price Discrimination
Charging different prices to different customer groups for the same product for reasons
unrelated to cost in order to increase profits
Examples:
(Off-)Peak Pricing - not price discrimination, the products are different
Different Classes - not price discrimination, the products are different
Discounts - tend to be price discrimination, as the price is different for the same product
Price discrimination requires:
Different price elasticities of demand in each sub-market (e.g. OAP vs. business traveller)
No market seepage (i.e. reselling between sub-markets is impossible)
Firms are price-makers (i.e. operate in an imperfectly competitive market)
There are three types of price discrimination:
[edit]First Degree Price Discrimination
Must know how much each customer is willing to pay
Not very likely
e.g. Allocation of limited seats to the highest bidder first
All consumer surplus transferred to the firm:

[edit]Second Degree Price Discrimination
Selling off excess capacity at lower prices than previously charged
e.g. Airlines after 9/11
Used when a firm is:
left with huge amounts of capacity
desperate to maintain cash flow
need to increase occupancy rate
A firm sells at a price initially, but clears at the marginal cost of each unit
Employed by European low-cost airlines:
Attempt to fill all seats
Increase price progressively as seats are sold
Flight revenue and profits are maximised
Strategy explains strong sales growth over recent years
[edit]Third Degree Price Discrimination
Allows firms to increase revenue and profit by charging different prices for the same
product to different market segments
e.g. rail travel:
For students, the fare is a higher % of income meaning student demand is price
elastic
For commuters, the fare is a lower % of income meaning commuter demand is more
price inelastic
For business travellers, the fare is almost irrelevant meaning business traveller
demand is extremely price inelastic
[edit]Costs
Most business decision made in SR
Businesses will initially experience "increasing returns"
Eventually, "diminishing returns" will be experienced
In SR:
Output increases at an increasing rate initially, then at a decreasing rate
Fixed costs stay the same
Variable costs increase with output
Total costs will increase with output
MC falls initially


In LR:
Businesses typically benefit from economies of scale
This leads to a lower AC in LR
At a certain point, AC plateaus (productive efficiency)
Beyond the plateau, a business experiences diseconomies of scale
Economies of scale are important because they motivate businesses to develop. There are
two types of economy of scale and two matching types of diseconomies of scale:
[edit]Internal Economies of Scale
Those economies of scale accrued within a business (business-specific). For example:
Technical: Improved use of technology/machinery
Financial: More, cheaper sources of finance available
Marketing Budget: need not increase proportionally
Purchasing: Bulk-purchase discounts
Research & Development: Budget need not increase proportionally
Managerial: Cost of management become more dissipated
[edit]External Economies of Scale
Those economies of scale that a market can exploit. For example:
A readily available skilled workforce
Locally accessible specialist suppliers
Good transport network
[edit]Internal Diseconomies of Scale
These diseconomies of scale may be caused by:
Division of labour benefits fully exploited
Management out of touch
Slower decision-making
Poorer communication
Worsening labour relationships
[edit]External Diseconomies of Scale
These diseconomies of scale may arise when:
Resources are scarce
There is congestion on the transport network
[edit]Revenues
Revenue patterns depend on the type of market. For example:
In a perfectly competitive market, MR doesn't change.
In an imperfectly competitive market,
[edit]Profit
Profit = TR - TC
Reward for risk-taking
Cost of entrepreneurship
Two types of profit:
Normal: The minimum profit needed to continue trading
Abnormal: Anything above normal profit
Economics assumes that firms are profit-maximisers.
Profit-maximising output is where MC = MR
Profit-maximising price is AR above MC = MR
Economics does recognise other objectives:
Survival
Growth
Profit
Meeting needs of stakeholders
[edit]Definitions
Allocative efficiency: the efficiency with which markets are allocating resources. A
market will be allocatively efficient if it is producing the right goods for the right people at
the right price. Alternatively, you cannot make anyone better off without making
someone else worse off.
Average revenue (AR): the TR divided by the level of output. It is equivalent to the
price because it is the revenue the firm receives for each unit.
Barriers to entry/exit: barriers that prevent the entry of new firms into a market.
Barriers to entry may be technical barriers, legal barriers, cost (or investment) barriers or
barriers that arise from strong branding of the product.
Bilateral: affecting or undertaken by two sides equally, binding on both parties.
Business cycle: the tendency of economies to move, over time, through periods of
boom and slump. In other words, the fluctuations in the rate of economic growth that
take place in the economy. (aka trade cycle)
Captive consumers: consumers who do not have any choice as to how they access a
service/product. Often occurs within a monopoly.
Congestion: over-crowding of a particular service/resource.
Consumer surplus: when people are able to buy a good for less than they would have
been willing to pay. In other words they are receiving an effective benefit from buying
the good. The consumer surplus is shown as the area between the equilibrium price and
the demand curve.
Contestable market: a market in which there is always a threat or possibility of
competition. This will still have the effect of making firms in the industry behave as if it is
competitive as they will be concerned about the threat of other firms entering the
market.
Cross elasticity of demand (XED): a measure of the responsiveness of demand for
one good to a change in the price of another. . If the value is
positive then the goods are substitutes, and if the value is negative then the goods are
complements.
Cross subsidisation: where one group pays a relatively high price and thus enables
another group to pay a relatively low price.
Deregulation: the removal of regulation or the removal of controls on a particular
market.
Derived demand: where the demand for one thing depends on the demand for another.
In other words the amount of demand for good A depends in turn on the amount of
demand for good B.
Diminishing returns: a situation where the addition of a variable factor of production
results in a fall in marginal product. The firm may be trying to expand by using more of
its variable factors, but finds that the extra output they get each time they add more of
the variable factor gradually falls.
Diseconomies of scale: a situation where average costs increase as production
increases. This is the opposite to economies of scale and often happens where there
are communication problems in larger organisations. They are also known as
decreasing returns to scale.
Economic growth: an increase in a country's total output of goods and services. It is
measured by changes in real GDP.
Economies of scale: where average cost falls as production increases. They are
happening because larger firms are able to lower their unit costs. This may happen for a
variety of reasons. A larger firm may be able to buy in bulk, it may be able to organise
production more effectively, it may be able to organise cheaper loans and so on. They
are also known as returns to scale.
Equity: a situation where the distribution of income is considered to be 'fair' or 'just'. An
equitable distribution will not be the same as an equal distribution of income.
Externalities: spillover effects from production or consumption for which no payment is
made. Externalities can be positive or negative.
Government intervention: when the government intervenes in a particular market. This
may mean the introduction of price controls or it may mean intervention buying and
selling in an attempt to stabilise the market.
Homogeneous product: all products are perceived to be of the same nature and value
by the consumer.
Income elasticity of demand (YED) a measure of the responsiveness of demand to a
change in income. . A positive figure means that the good is a
normal good whilst a negative figure means that the good is an inferior good.
Increasing returns: a situation where increasing the quantity-variable factor of
production causes marginal product to rise.
Inferior goods: goods where an increase in income leads to a fall in the quantity
consumed. They will have a negative income elasticity of demand.
Infrastructure:7 the basic underlying networks necessary to support economic activity.
This includes roads, bridges, ports, sewers, hospitals and schools.
Interdependence: when the actions of one firm has an effect on its competitors. It is
common in oligopolistic market structures where there are only small numbers of firms.
Lead time: the time interval between the initiation and the completion of a production
process.
Legal monopoly: a market in which the government has allowed a particular firm to
become a monopolist.
Long run (LR): all factors of production are variable.
Marginal cost (MC): the cost of producing one extra unit. It is the increase in total cost
when one more unit is produced.
Marginal revenue (MR): the revenue earned from selling one more unit of a good or
service. It is the increase in total revenue that occurs when one more unit is sold.
Market clearing price: the price at which equilibrium between supply and demand is
reached.
Market seepage: no reselling between sub-markets.
Minimum Efficient Scale: lowest level of output at which the lowest AC occurs.
Modes of transport: methods of moving goods and passengers.
Natural monopoly: a situation where a single company tends to become the only
supplier of a product or service over time because the nature of that product or service
makes a single supplier more efficient than multiple, competing ones.
Non-excludability: once the good is provided it is not possible to stop people benefiting
from it.
Non-rivalry: consumption by one person does not reduce the amount available for
another.
Normal profit: the level of profit required for a firm to keep the resources they are using
in their current use. In other words it is enough profit to keep them in the industry.
Anything in excess of normal profits is called abnormal or supernormal profits.
Peaking: demand for a good is higher at a particular time.
Perishable goods: goods which have a limited life-span from when they are produced.
Predatory pricing: where a firm reduces price in the short run to try to force
competitors out of the industry.
Price elasticity of demand (PED): a measure of the responsiveness of demand to a
change in price. If a good is elastic (a value for the elasticity of
more than one), it is considered to be responsive to changes in price. If inelastic (a
value below one) then it is unresponsive.
Price makers: firms who are able to influence price as their output represents a
significant share of the market. Firms in monopoly and oligopoly will tend to have a high
level of price setting power.
Price takers: firms whose output does not influence price.
Private sector: the part of the economy privately owned and in the control of individuals
and companies.
Privatisation: the process of moving economic activity from the public sector to the
private sector. The most common form of privatisation is the sale of government-owned
shares in private sector companies or the sale of whole companies to private investors.
Producer surplus: the difference between the minimum price a producer would accept
to supply a given quantity of a good and the price actually received. It is the gap
between the marginal cost curve (supply curve) and the equilibrium price.
Productive efficiency: when a firm produces at the lowest unit cost. This will be at the
minimum point of the average cost curve (where MC = AC).
Profit maximisers: firms which aim to make the highest level of profit possible (the
largest surplus of revenue over cost) as opposed to other objectives.
Public goods: goods that would not be provided in a pure free-market system. This is
because they display non-rivalry and non-excludability.
Public sector: the section of the economy under government control. In the UK it
includes the health and education services, the police, fire service and ambulance
service.
Quasi-privatisation: the use of private sector money within the public sector.
Quasi-public good: a near-public good. It has many but not all the characteristics of a
public good.
Real: excluding the effects of inflation.
Resource mobility: the ease with which resources can move between different uses
and locations.
Revenue: the money received from the sale of output.
Short run (SR): at least one factor of production is fixed.
Subsidies: payments made to firms or consumers designed to encourage an increase
in output. A subsidy will shift the supply curve to the right and therefore lower the
equilibrium price in a market.
Sunk costs: unrecoverable past expenditure.
Supernormal profit: when profit exceeds the amount a firm must receive to carry on
production. If supernormal profits persist in an industry this will tend to attract new firms
in, supply will increase, prices will fall and normal profits will be restored in the industry.
Tender: companies bid for the lowest subsidy they would need to complete the work
required.
Total revenue (TR): the number of goods sold multiplied by the price charged for each
one.
Total cost (TC): the total amount spent by a firm on producing a given level of output. It
is made up of the fixed costs and the variable costs of production.
Transport: the movement of goods and passengers from one place to another.
Urbanisation: the social process whereby cities grow and societies become more
urban.