HomeNotesEconomics – 04553.

8 – Market Structure

Competitive Markets
Firms compete in the market to increase their customer base, sales, market share and profits.

Price competition involves competing to offer consumers the lowest or best possible prices of a
product. Non-price competition is competing on all other features of the product (quality, after-sales
care, warranty etc.) other than price.
Informative advertising means providing information about the product to consumers. Examples include
advertising of phones, computers, home appliances etc. which include specific information about their
technical features.
Persuasive advertising is designed to create a consumer want and persuade them to buy the product in
order to boost sales. Examples include advertisements of perfumes, clothes, chocolates etc.
Pricing Strategies
What can influence the price that producers fix on a product?

● Level and strength of consumer demand.

● The amount of competition from rival producers in the market.
● The cost of production and the level of profit targeted.
Price skimming: When a new and unique product enters the market, its producers charge a very high
price for it initially as consumers will be willing to pay more for the new product. As more competitors
begin to launch similar products, producers may lower prices. Apple’s iPhones are good examples – they
are very expensive at launch and get cheaper overtime.
Penetration pricing: when producers set a very low price which encourages consumers to try the
product, helping expand sales and increase loyalty. This way, the product is able to penetrate a market,
especially useful when there are a lot of existing rival products. Netflix, when it first started out as a DVD
rental service, used penetration pricing ($1 monthly subscription!) to encourage customers to try their
service which helped it create a large customer base.
Destruction pricing (predatory pricing): prices are kept very low (lower than the cost of production per
unit) in order to ‘destroy’ the sales of existing products, as consumers will turn to the lowest priced
products. Once the product is successful, it can raise prices and cover costs. India’s Reliance Jio, a
telecom company, was accused of predatory pricing during its initial launch years. Predatory pricing is
illegal in many countries as it creates a non-competitive business environment and encourages monopoly
practices.
Price wars happen when competing firms continually trying to undercut each other’s prices.
Cost-plus-pricing: this involves calculating the average cost of producing each unit of output and then
adding a mark-up value for profit.
Price = (Total Cost/Total Output) + Mark-up
This ensures that the cost of production is covered and that each unit produces a profit.

Perfect Competition
In a perfectly competitive market, there will be many sellers and many buyers – a lot of different firms
compete to supply an identical product.
As there is fierce competition, neither producers nor consumers can influence market price – they
are all price takers. If any firm did try to sell at a high price, it would lose customers to competitors. If the
price is too low, they may incur a loss. There will also be a huge amount of output in the market.
Advantages:
● High consumer sovereignty: consumers will have a wide variety of goods and services to
choose from, as many producers sell similar products. Products are also likely to be of high
quality, in order to attract consumers.
 ● Low prices: as competition is fierce, producers will try and keep prices low to attract customers
and increase sales.
● Efficiency: to keep profits high and lower costs, firms will be very efficient. If they aren’t efficient,
they would become less profitable. This will cause them to raise prices which would discourage
consumers from buying their product. Inefficiency could also lead to poor quality products.
Disadvantages:
● Wasteful competition: in order to keep up with other firms, producers will duplicate items; this is
considered a waste of resources.
● Mislead customers: to gain more customers and sales, firms might give false and exaggerated
claims about their product, which would disadvantage both customers and competitors.

Monopoly
Dominant firms who have market power to restrict competition in the market are called
monopolies. In a pure monopoly, there is only a single seller who supplies a good or service. Example:
Indian Railways. Since customers have no other firms to buy from, monopolies can raise prices – that is
they are able to influence prices as it will not affect their profitability. These high prices result in
monopolies generating excessive or abnormal profits.
Monopolies don’t face competition because the market faces high barriers to entry – obstacles
preventing new firms from entering the market. That is, there might be high start-up costs (sunk costs),
expensive paperwork, regulations etc. If the monopoly has a very high brand loyalty or pricing structures
that other firm couldn’t possibly compete with, those also act as barriers to entry.
Disadvantages:
● There is less consumer sovereignty: as there are no (or very little) other firms selling the
product, output is low and thus there is little consumer choice.
● Monopolies may not respond quickly to customer demands.
● Higher prices.
● Lower quality: as there is little or no competition, monopolies have no incentive to raise quality,
as consumers will have to buy from them anyway. (But since they make a lot of profit, they may
invest a lot in research and development and increase quality).
● Inefficiency: With high prices, they may create high enough profits that, costs due to inefficiency
won’t create a significant problem in their profitability and so they can continue being inefficient.
Why monopolies are not always bad?
● As only a single producer exists, it will produce more output than what individual firms in a
competition do, and thus benefit from economies of scale.
● They can still face competition from overseas firms.
● They could sell products at lower price and high quality if they fear new firms may enter the
market in the future.

Costs of Production
Fixed costs (FC) are costs that are fixed in the short-term running of a business and have to
be paid even when no production is taking place. Examples: rent, interest on bank loans,
telephone bills. These costs do not depend on the amount of output produced.
Average Fixed Cost (AFC) = Total Fixed Cost (TFC) / Total Output

Variable costs (VC) are costs that are variable in the short-term running of a business and are
paid according to the output produced. The more the production, the more the variable costs
are. Examples: wages, electricity bill, cost of raw materials.
Average Variable Cost (AVC) = Total Variable Costs (TVC) / Total Output

Total Costs (TC) = Total Fixed Costs (TFC) + Total Variable Costs (TVC)

This is a simple graph showing the relation between TC, FC

and VC. The gap between the TC and TVC indicates the TFC
Average cost or Average total Cost (ATC) is the cost per unit of output.
Average Total Cost (ATC) = Total Cost (TC) / Total Output or
Average Cost (AC) = Average Variable Cost (AVC) + Average Fixed Cost (AFC)

(Remember ‘average’ means ‘per unit’ and so will involve dividing the particular cost by the
total output produced. In the graphs above you will notice that the average variable costs and
average total costs first fall and then start rising. This is because of economies of scale and
diseconomies of scale respectively. As the firm increases its output, the average costs decline
but as it starts growing beyond a limit, the average costs rise).

Let’s calculate some costs in an example:

Suppose, a TV manufacturer produces 1000 TVs a month. The firm’s fixed costs in rent is $900,
and variable cost per unit is $500. What would its TFC, TVC, AVC, AFC, AC and TC be, in a
month?

No. of units of TVs produced = 1000

Total Fixed Costs for one month = $900

Average Fixed Cost = $900 / 1000 = $0.9 per unit

Variable Cost of producing one unit of TV = $500

Total Variable Costs for producing 1000 TVs in a month = $500 * 1000 = $500,000
Average Variable Cost = $500,000 / 1000 = $500 (AVC is the same as VC per unit!)

Total Costs = Total Fixed Costs + Total Variable Costs ==> $900 + $500,000 = $500,900
Average Costs = Total Costs / Total Output ==> $500,900 / 1000 = $500.9
or Average Costs = AFC + AVC ==> $0.9 + $500 ==> $500.9

Revenue
Revenue is the total income a firm earns from the sale of its goods and services. The more the
sales, the more the revenue.
Total Revenue (TR) = No. of units sold (Sales) * Price per unit (P)
Average Revenue = Total Revenue (TR) / No. of units sold (Sales) (= Price per unit (P)!)
Suppose, from the example above, a TV is sold at $800 and the firm sells all the units it produces,
what is the firm’s Total Revenue and Average Revenue, for a month?
No. of units sold (Sales) in a month = No. of units produced in a month = 1000
Total Revenue = Sales * Price ==> 1000 * $800 = $800,000
Average Revenue = Total Revenue / Sales = $800,000 / 1000 = $800

Total Revenue – Total Cost = Profit

Objectives of Firms
Objectives vary with different businesses due to size, sector and many other factors. However,
many business in the private sector aim to achieve the following objectives.

● Survival: new or small firms usually have survival as a primary objective. Firms in a highly
competitive market will also be more concerned with survival rather than any other objective. To
achieve this, firms could decide to lower prices, which would mean forsaking other objectives
such as profit maximization.
● Profit: profit is the income of a business from its activities after deducting total costs from total
revenue. Private sector firms usually have profit making as a primary objective. This is because
profits are required for further investment into the business as well as for the payment of
return to the shareholders/owners of the business. Usually, firms aim to maximise their
profits by either minimising costs, or maximising revenue, or both.
● Growth: once a business has passed its survival stage it will aim for growth and expansion. This
is usually measured by value of sales or output. Aiming for business growth can be very
beneficial. A larger business can ensure greater job security and salaries for employees. The
business can also benefit from higher market share and economies of scale.
● Market share: market share can be defined as the sales in proportion to total market sales
achieved by a business. Increased market share can bring about many benefits to the business
such as increased customer loyalty, setting up of brand image, etc.
● Service to the society: Some operations in the private sectors such as social enterprises do not
aim for profits and prefer to set more social objectives. They aim to better the society by aiding
society financially or otherwise.
● A business’ objectives do not remain the same forever. As market situations change
and as the business itself develops, its objectives will change to reflect its current
market and economic position. For example, a firm facing serious economic recession
could change its objective from profit maximization to short term survival.

Demand for Factors of Production

Some factors that determine the demand of factors of production:

 ● The demand for the product: if more goods and services are demanded by consumers, more
factors of production will be demanded by firms to produce and satisfy the demand. That is, the
demand for factors of production is derived demand, as it is determined by the demand for the
goods and services (just like labour demand).

● The availability of factors: firms will also demand factors that are easily available and
accessible to them. If the firm is located in a region where there is a large pool of skilled labour, it
will demand more labour as opposed to capital.

● The price of factors: If labour is more expensive than capital, firms will demand more capital
(and vice versa), as they want to reduce costs and maximize profits.

● The productivity of factors: If labour is more productive than capital, then more labour is
demanded, and vice versa.

Labour-intensive and Capital-intensive production

Labour-intensive production is where more labourers are employed than other factors, say capital.
Production is mainly dependent on labour. It is usually adopted in small-scale industries, especially those
that produce personalised, handmade products. Examples: hotels and restaurants.

Advantages:

● Flexibility: labour, unlike most machinery can be used flexibly to meet changing levels of
consumer demand, e.g., part-time workers.

● Personal services: labour can provide a personal touch to customer needs and wants.

● Personalised services: labourers can provide custom products for different customers.
Machinery is not flexible enough to provide tailored products for individual customers.

● Gives feedback: labour can give feedback that provides ideas for continuous improvements in
the firm.

● Essential: labour is essential in case of machine breakdowns. After all, machines are only as
good as the labour that builds, maintains and operates them..

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Disadvantages:

● Relatively expensive: in the long-term, when compared to machinery, labour has higher per unit
costs due to lower levels of productivity.

● Inefficient and inconsistent: compared to machinery, labour is relatively less efficient and tends
to be inconsistent with their productivity, with various personal, psychological and physical
matters influencing their quantity and quality of work.

● Labour relation problems: firms will have to put up with labour demands and grievances. They
could stage an overtime ban or strike if their demands are not met.

Capital refers to the machinery, equipment, tools, buildings and vehicles used in production. It also means
the investment required to do production. Capital-intensive production is where more capital is
employed than other factors. It is a production which requires a relatively high level of capital investment
compared to the labour cost. Most capital-intensive production is automated (example:
car-manufacturing).

Advantages:
 ● Less likely to make errors: Machines, since they’re mechanically or digitally programmed to do
tasks, won’t make the mistakes that labourers will.

● More efficient: machinery doesn’t need breaks or holidays, has no demands and makes no
mistakes.

● Consistent: since they won’t have human problems and are programmed to repeat tasks, they
are very consistent in the output produced.

● Technical economies of scale: increased efficiency can reduce average costs

Disadvantages:

● Expensive: the initial costs of investment is high, as well as possible training costs.

● Lack of flexibility: machines need not be as flexible as labourers are to meet changes in
demand.

● Machinery lacks initiative: machines don’t have the intuitive or creative power that human
labour can provide the business, and improve production.

Production and Productivity

A firm combines scarce resources of land, labour and capital (inputs) to make (produce) goods and
services (output). Production is thus, the transformation of raw materials (input) to finished or
semi-finished goods and services (output).
In other words, production is the adding of value to inputs to create outputs. It is the production that gives
the inputs value.

Some factors that influence production:

● Demand for product: the more the demand from consumers, the more the production.

● Price and availability of factors of production: if factors of production are cheap and readily
available, there will be more production.

● Capital: the more capital that is available to producers, the more the investment in production.

● Profitability: the more profitable producing and selling a product is, the more the production of
the product will be.

● Government support: if governments give money in grants, subsidies, tax breaks and so on,
more production will take place in the economy.

Productivity measures the amount of output that can be produced from a given amount of input
over a period of time.
Productivity = Total output produced per period / Total input used per period

Productivity increases when:

● more output or revenue is produced from the same amount of resources

● the same output or revenue is produced using fewer resources.

(Labour productivity is the measure of the amount of output that can be produced by each worker in a
business).

Factors that influence productivity:

 ● Division of labour: division of labour is when tasks are divided among labourers. Each labourer
specializes in a particular task, and thus this will increase productivity.

● Skills and experience of labour force: a skilled and experienced workforce will be more
productive.

● Workers’ motivation: the more motivated the workforce is, the more productive they will be.
Better pay, working conditions, reasonable working hours etc. can improve productivity.

● Technology: more technology introduced into the production process will increase productivity.

● Quality of factors of production: replacing old machinery with new ones, preferably with latest
technologies, can increase efficiency and productivity. In the case of labour, training the workforce
will increase productivity.

● Investment: introducing new production processes which will reduce wastage, increase speed,
improve quality and raise output will raise productivity. This is known as lean production.

BROWNSVILLE COLLGE, IKOYI

YEAR 10 ECONOMICS T3
FIRMS
Classification of Firms

Firms can be classified in terms of the sectors they operate in and their relative sizes.

Firms are classified into the following three categories based on the type of operations undertaken by
them:

Primary: all economic activity involving extraction of raw natural materials. This includes agriculture,
mining, fishing etc. In pre-modern times, most economic activity and employment was in this sector,
mostly in the form of subsistence farming (farming for self-consumption).

Secondary: all economic activity dealing with producing finished goods. This includes construction,
manufacturing, utilities etc. This sector gained importance during the industrial revolution of the 19th and
20th centuries and still makes up a huge part of the modern economy.

Tertiary: all economic activity offering intangible goods and services to consumers. This includes retail,
leisure, transport, IT services, banking, communications etc. This sector is now the fastest-growing sector
as consumer demand for services have increased in developed and developing nations.

Firms can also be classified on the basis of whether they are publicly owned or privately owned:

Public: this includes all firms owned and run by the government. Usually, the defence, arms and nuclear
industries of an economy are completely public. Public firms don’t have a profit motive, but aim to provide
essential services to the economy it governs. Governments do also run their own schools, hospitals,
postal services, electricity firms etc.
Private: this includes all firms owned and run by private individuals. Private firms aim at making profits
and so their products are those that are highly demanded in the economy.

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Firms can also be classified on their relative size as small, medium or large depending on the output,
market share, organisation (no. of departments and subsidiaries etc).

Small Firms

A small firm is an independently owned and operated enterprise that is limited in size and in revenue
depending on the industry. They require relatively less capital, less workforce and less or no machinery.
These businesses are ideally suited to operate on a small scale to serve a local community and to provide
profits to the owners.

Advantages of small businesses:

Independence: owner(s) are free to run the business as he/she pleases.

Control: the owner(s) has full control over the business, unlike in a large business where multiple
managers, departments and branches will exist.

Flexibility: small businesses can adapt to quick changes as the owner is more involved in the
decision-making.

Better communication: since there are fewer employees, information can be intimated easily and quickly.

Innovation: small businesses can tend to be innovative because they have less to lose and are willing to
take risks.

Disadvantages of small businesses:

Higher costs: small firms cannot exploit economies of scale – their average costs will be higher than
larger rivals.

Lack of finance: struggles to raise finance as choice of sources of acquiring finance is limited.

Difficult to attract experienced employees: a small business may be unable to afford the wage and
training required for skilled workers.

Vulnerability: when economic conditions change, it is harder for small businesses to survive as they lack
resources.

Small firms still exist in the economy for several reasons:

Size of the market: when there is only a small market for a product, a firm will see no point in growing to a
larger size. The market maybe small because:

the market is local – for example, the local hairdresser.

the final product maybe an expensive luxury item which only require small-scale production (e.g.
custom-made paintings)

personalised/custom services can only be given by small firms, unlike large firms that mostly give
standardised services (e.g. wedding cake makers).

Access to capital is limited, so owners can’t grow the firm.

Owner(s) prefer to stay small: a lot of entrepreneurs don’t want to take risks by growing the firm and they
are quite satisfied with running a small business.

Small firms can co-operate: co-operation between small firms can lead them to set up jointly owned
enterprises which allow them to enjoy many of the benefits that large firms have.

Governments help small firms: governments usually provide help to small scale firms because small firms
are an important provider of employment and generate innovation in the production process. In most
countries, it is the medium and small industries that contribute much of the employment.

Growth of Firms

When a firm grows, its scale of production increases. Firms can grow in to ways: internally or externally.

Internal Growth/Organic Growth

This involves expanding the scale of production of the firm’s existing operations. This can be done by
purchasing more machinery/equipment, opening more branches, selling new products, expanding
business premises, employing more workers etc.

External Growth

This involves two or more firms joining together to form a larger business. This is called integration. This
can be done it two ways: mergers or takeovers.

A takeover or acquisition happens when a company buys enough shares of another firm that they can
take full control. The firm taken over loses its identity and becomes a part of what is known as the holding
company. A well-known example would be Facebook’s acquisition of Whatsapp in 2014.

A merger occurs when the owners of two or more companies agree to join together to form a firm.

Mergers can happen in three ways:

Horizontal Integration: integration of firms engaged in the production of the same type of good at the
same level of production. Example: a cloth manufacturing company merges with another cloth
manufacturing company.

Advantages:
Exploit internal economies of scale: including bulk-buying, technical economies, financial economies.

Save costs: when merging, a lot of the duplicate assets including employees can be laid off.

Potential to secure ‘revenue synergies’ by creating and selling a wider range of products.

Reduces competition: by merging with key rivals, the two firms together can increase market share.

Disadvantages:

Risk of diseconomies of scale: a larger business will bring with a lot of managerial and operational issues
leading to higher costs.

Reduced flexibility: the addition of more employees and processes means the need for more
transparency and therefore more accountability and red tape, which can slow down the rate of innovating
and producing new products and processes.

Vertical Integration: integration of firms engaged in the production of the same type of good but at
different levels of production (primary/secondary/tertiary). Example: a cloth manufacturing company
(secondary sector) merges with a cotton growing firm (primary sector).

Forward vertical integration: when a firm integrates with a firm that is at a later stage of production than
theirs. Example: a dairy farm integrates with a cheese manufacturing company.

Backward vertical integration: when a firm integrates with a firm that is at an earlier stage of production
than theirs. Example: a chocolate retailer integrates with a chocolate manufacturing company.

Advantages:

It can give a firm assured supplies or outlets for their products. If a coffee brand merged with coffee
plantation, the manufacturers would get assured supplies of coffee beans from the plantation. If the coffee
brand merged with a coffee shop chain, they would have a permanent outlet to sell their coffee from.

Similarly, one firm can prevent the other firm from supplying materials or selling products to competitors.
The coffee brand can have the coffee plantation to only supply them their coffee beans. The coffee brand
can also have the coffee shop chain only selling coffee with their coffee powder.

The profit margins of the merged firm can now be absorbed into the merging firm.

The firms can increase their market share and become more competitive in the market.

Disadvantages:

Risk of diseconomies of scale: a larger business will bring with a lot of managerial and operational issues
leading to higher costs

Reduced flexibility: the addition of more employees and processes means the need for more
transparency and therefore more accountability and red tape, which can slow down the rate of innovating
and producing new products and processes

It’s a difficult process: The firms, when vertically integrated, are entering into a stage of production/sector
they’re not familiar with, and this will require staff of either firm to be educated and trained. Some might
even lose their jobs. It can be expensive as well.

Lateral/Conglomerate integration: this occurs when firms producing different type of products integrate.
They could be at the same or different stages of production. Example: a housing company integrates with
a dairy farm. Thus, the firm can produce a wide range of products. This helps diversify a firm’s operations.
Advantages:

Diversify risks: conglomerate integration allows businesses to have activities in more than one market.
This allows the firms to spread their risks. In case one market is in decline, it still has another source of
profit.

Creates new markets: merging with a firm in a different industry will open up the firm to a new customer
base, helping it to market its core products to this new market.

Transfer of ideas: there could be a transfer of ideas and resources between the two businesses even
though they are in different industries. This transfer of ideas could help improve the quality and demand
for the two products.

Disadvantages:

Inexperience can lead to mismanagement: if the firms are in entirely different industries and have no
experience in the other’s industry, cooperating and managing the two industries may be difficult and could
turn disastrous.

Lose focus: merging with and focusing on an entirely new industry could cause the firm to lose focus of its
core product.

Culture clash: as with all kinds of mergers, there could be a culture clash between the two firms’
employees on practices, standards and ‘how things are done’.

Scale of Production

As a firm’s scale of production increases its average costs decrease. Cost saving from a large-scale
production is called economies of scale.

Internal economies of scale are decisions taken within the firm that can bring about economies
(advantages). Some internal economies of scale are:

Purchasing economies: large firms can be buy raw materials and components in bulk because of their
large scale of production. Supplier will usually offer price discounts for bulk purchases, which will cut
purchasing costs for the firm.

Marketing economies: large firms can afford their own vehicles to distribute their products, which is much
cheaper than hiring other firms to distribute them. Also, the costs of advertising is spread over a much
large output in large firms when compared to small firms.

Financial economies: banks are more willing to lend money to large firms since they are more financially
secure (than small firms) to repay loans. They are also likely to get lower rates of interest. Large firms
also have the ability to sell shares to raise capital (which do not have to be repaid). Thus, they get more
capital at lower costs.

Technical economies: large firms are more financially able to invest in good technology, skilled workers,
machinery etc. which are very efficient and cut costs for the firm.

Risk-bearing economies: large firms with a high output can sell into different markets (even overseas).
They are able to produce a variety of products (diversification in production). This means that their risks
are spread over a wider range of products or markets; even if a market or product is not successful, they
have other products and markets to continue business in. Thus, costs are less.

External economies of scale occur when firms benefit from the entire industry being large. This may
include:

Access to skilled workers: large firms can recruit workers trained by other firms. For example: when a new
training institution for pilots and airline staff opens, all airline firms can enjoy economies of scale of having
access to skilled workers, who are more efficient and productive, and cuts costs.

Ancillary firms: they are firms that supply and provide materials/services to larger firms. When ancillary
firms such as a marketing firm locates close to a company, the company can cut costs by using their
services more cheaply than other firms.

Joint marketing benefits: when firms in the same industry locate close to each other, they may share an
enhanced reputation and customer base.

Shared infrastructure: development in the infrastructure of an industry or the economy can benefit large
firms. Examples: more roads and bridges by the govt. can cut transport costs for firms, a new power
station can provide cheaper electricity for firms.

Diseconomies of scale occur when a firms grows too large and average costs start to rise. Some common
diseconomies are:

Management diseconomies: large firms have a wide internal organisation with lots of managers and
employees. This makes communication difficult and decision-making very slow. Gradually, it leads to
inefficient running of the firms and increases costs.

Too much output may require a large supply of raw materials, power etc. which can lead to shortage and
halt production, increasing costs.

Large firms may use automated production with lots of capital equipment. Workers operating these
machines may feel bored in doing the repetitive tasks and thus become demotivated and less
cooperative. Many workers may leave or go on strikes, stopping production and increasing costs.

Agglomeration diseconomies: this occurs when firms merge/acquire too many different firms producing
different products, and the managers and owners can’t coordinate and organise all activities, leading to
higher costs.

More shares sold into the market and bought means more owners coming into the business. Having a lot
of owners can lead to a lot of disputes and conflicts among themselves.

A lot of large firms can face diseconomies when their products become too standardised and less of a
variety in the market. This will reduce sales and profits and increase average costs.

A firm that doubles all its inputs (resources) and is able to more than double its output as a result,
experiences increasing returns to scale.

A firm that doubles all its inputs and fails to double its output as a result, experiences a decreasing or
diminishing returns to scale.