Increase in demand

Fall in demand

Fall in Price

Fall in supply and demand

Fall in supply

Increase Demand

Increase supply, demand and quantity

Diagram of Fall In Supply

Scarcity in a Free Market

If there is scarcity of a good the supply will be falling. This scarcity causes the price to rise. In a free market this rising price acts as a signal and therefore demand for the good falls. Also the higher price of the good provides incentives for firms to:

• Look for alternative sources of the good e.g. new supplies of oil from antarctic
• Look for alternatives e.g. solar panel cars

Therefore, in a free market there are incentives for the market mechanims to deal with the issue of scarcity.

However, the market can also have market failure. For example, firms may not think about the future until it is too late. Therefore, when the good becomes really scarce there might not be any alternative that has been developed.

Quotas.

One solution to dealing with scarcity is to implement quotas on how much people can buy. An example of this is the rationning system that occured in the Second World War. Because there is a scarcity of food, the government had strict limits on how much people could get. This was to ensure that even people with low incomes had access to food a basic necessity.

A problem of quotas is that it can lead to a black market; for some goods people are willing to pay high amounts to get extra food. Therefore, it can be difficult to police a rationning system. But, it was a necessary policy for second world war.

Interesting question. I think it is an open ended question with many different possibilities. One approach is to think how firms in different industries may behave if they did merge. Bearing in mind the model of monopolistic competition doesn’t always stand up to scrutiny too well in the real world.

A monopolistic competitive industry has the following features:

• Many Firms
• Freedom of entry and exit
• Produce differentiated Products. Therefore firms have inelastic demand, they are price makers because the good is highly differentiated
• Make Normal Profits in the Long Run, but could make supernormal profits in the short term
• Are allocatively and productively inefficient.

Examples of monopolistic competition might include:

• Restaurants.
• Hair dressers

If the firms merged together there is no certainty how they would behave.

In some industries it makes sense to have many differentiated brands creating an illusion of competition and providing a barrier to entry.

How Many soap powders are there? about 35. But, most of these brands are owned by 2 companies, Unilever and Proctor and Gamble. Having brand proliferation means it is harder for a new firm to enter the market. This is because a new firm would have to compete against 30 established brands as opposed to 2. There is less chance of getting a good market share with so many brands. Therefore the new firm would have an incentive to keep different brands in order to deter competitors.

However, if you have merge different brands there may be economies of scale. You can devote more resources and investment to improving that particular product and maximising its efficiency. This might be appropriate for an industry like computer software or computers. There used to be many different brands of computers, until the pc came to dominate.

Are the different brands catering to different sectors of the market. If you take the restaurant business, there is a big difference between Chinese and Indian. If 2 restaurants merge, they would be better off retaining distinct business. It would make no sense to have  a restaurant which offered a mixture of Chinese/Indian – consumers would trust it less.

If you fear the arrival of a powerful company, it might be good to consolidate your brands. For example, there are many small search engines, but they would be better off combining forces to compete against the mighty Google.

•  Oligopoly
• UK Mergers 

Q. Use economics and political theory to explain why the fire and rescue service should be provided by the state. I dont want the answer….I just don’t understand what this means.

This revolves around a fundamental debate in economics – How much should the government intervene in the economy.

Ideally, goods and services would be provided in a free market, without requiring any government intervention. Market provision is considered superior because there is less bureaucracy and more incentives for firms to be efficient.

However, there are some goods and services which will be underprovided in a free market. (some goods may not be provided at all). This is considered a type of market failure and therefore for several reasons people argue the government should step in and provide it.

Examples of Goods underprovided include merit goods and public goods.

Fire service could be considered a public good. Because fire prevention and fire extinguishing services share the characteristics of public goods. Therefore, this question is saying

• What are the reasons for government provision of fire services. What are the arguments against. Because it is a public good you can provide good reasons why government should intervene.
• If the question was should government provide DVDs then the answer would be very different – DVDs are not an essential public good.

Readers Question Could you explain the above diagram.

The above diagram shows a fundamental aspect of economics – supply and demand.

The supply of petroleum is the quantity produced and sold on to the open market. The initial price of petrol is at P0 where Supply equals demand.

However, if the supply of petrol increased to S1 there would be a surplus of petrol at the price p0. Basically there would be more petrol than people want to consume. It is no good for firms to have excess supply because they are not getting anything for it.

Therefore, to encourage demand firms reduce price; as the price falls more people are encouraged to buy it. Thus the price will fall to P1 where the market regains equilibrium (supply = demand). As long as supply does not equal demand there is always a tendency for prices to change.

In recent months the supply of oil has been falling, causing oil prices to rise.

Note: the one criticism of the diagram is that I don’t believe the demand for petrol is so elastic. I think the demand for petrol is inelastic – which means an increase in supply would cause a big fall in price.

• Printer Ink is expensive – $8,000 per gallon.

1. Printers are sold Cheaply, this market is very competitive. On selling printers the profit margins are very low. Therefore, the firms need to make money in other areas.
2. Ink provides a way to get an improved profit margin. Once you have a printer, the firm has a captive audience – you will be reluctant to buy a new printer just because the ink is expensive.
3. Vertical Restraints – Big printing companies like Hewlett Packard, allegedly, have been preventing other 3rd party firms from selling ink. This is essential to maintain their monopoly power. To prevent other firms selling ink cheaply big printer firms can
   • Technology – electronic chips make it difficult for other firms to provide replacements.
   • Deals with Big Shops. It has been alleged that Hewlett Packard have been paying Staples to stop selling alternatives. Staples gets a bonus from Hewlett Packard, and Hewlett Packard can sell their cartridges at a high price.

Tips for Buying Printers

I like this article because recently I bought a Hewlett Packard printer for £50. I then realised a set of ink cartridges was over £20. Furthermore, they made the cartridges very small. And, there was no option to buy alternative cartridges.

Choose a printer where you are able to get cheap ink as well.

• Does Microsoft have too much Monopoly power ?
• Monopoly power in Electronic Markets 

(a)A perfectly competitive firm uses one variable and one fixed factor of production to make a single product. The price of the fixed factor rises by 10%, the price of the variable factor by 5% and the price of the good by 5%. In the new situation will the firm produce more, less or the same amount as it did before? Show your reasoning.

In long Run equilibrium, firms in perfect competition

• Produce where MR=MC. This is the level of profit maximisation
• Make Normal Profit AR=ATC

A rise in the variable factor by 5% will increase the marginal cost of production by 5%. But if the price rises by 5%. The AR and MR will increase by 5%.

Therefore, price will rise, but output should stay the same.

However, if the price of fixed factor rises by 10% there will be a bigger increase in the average total cost. If the firm was making normal profit, it will now make a loss. Because costs have increased more than price.
Therefore, in the long run, some firms in perfect competition will go out of business. Causing the supply of firms to fall and price to rise. This means that the AR of firms will increase and there will be an increase in production, by existing firms.
This really needs a diagram of perfect competition for individual firms and the market.

(I think this is what happens, but, it is not something I usually teach)

• Perfect Competition
• Efficiency in Perfect Competition

Cadbury’s the manufacturer of Dairy Milk, have warned that the price of chocolate is expected to rise next year by 5-6%. The main reason for this is an increase in the cost of raw materials such as cocoa, milk and oil.

Cocoa is one of the world’s largest traded commodity. It’s rise in price has mirrored many other commodities that have also seen rises in price. The reason for the rising price of cocoa is due to:

• Lower than expected supply from countries such as Ghana.
• Growing Demand, including demand from emerging economies such as China.
• Strong demand from domestic markets like the UK and US.

Yesterday, also came news that factory gate inflation had rise to 4.5% (link) This is the highest rate of factory inflation since 1991. This makes the prospect of future interest rate cuts less likely.

Both Nestle (maker of Kit Kat) and Cadbury’s (relaunching Wispa) have reported strong growth recently. Suggesting that rising prices may do little to effect demand. (Demand for chocolate is traditionally very price inelastic)

Related:

Fat Tax: Why we should tax unhealthy foods 

Market Power occurs when a firm has a significant share of the market – say greater than 25% of the market. When a firm has a large share of the market it can act in a way that is said to be an abuse of market power. Abuse of market power includes:

• Setting higher prices
• Offering less choice
• Restricting competition.
• Inefficient allocation of resources.

These abuses of market power can occur in various situations.

• Monopoly – firms has more than 25% of market share – easier to increase prices.
• Mergers – When 2 firms join together to form one. This usually results in an increase in market power which can lead to outcomes such as higher prices.
• Cartels – When firms agree to restrict output and set higher prices. Effectively they are acting as if there was one monopoly in the industry.

• Monopoly
• Does Microsoft have too much Monopoly power?
• UK Mergers

Readers Question: What effect it will have (on electricity market) if there is an introduction of subsidies to consumers who install green energy sources eg solar panels?

If there is a subsidy to green energy sources it will shift supply (of solar panels) to the right and therefore reduce the price of solar panels. The effect will be a slight reduction in demand for conventional electricity sources as some people now get energy from solar panels

However, even with a subsidy solar panels would be an expensive investment. Generally consumers are unwilling to invest money now, if it requires several years to make a return. Therefore, demand for solar panels is quite inelastic. In the short term there will only be a very small reduction in demand for conventional electricity.

A more effective way to increase renewable energy sources  would be government regulation to require new houses to be fitted solar panels.