J1

Topics
No.
Title
Page No.
1
Chapter 1: Scarcity, Choice and Opportunity Cost
2-3
2
Explain two ways in which an economy might move from a point within
4
its PPC to a point on it.
3
Discuss the most effective economic policies to move the PPC outwards.
5
4
What is meant by the basic economic problem of scarcity?
6
5
Discuss whether economic growth solves the problem of scarcity.
7
6
Chapter 2: Resource Allocation in Competitive Markets I
8-9
7
A manufacturer wishes to sell more of his product. How may he try to
10
achieve his aim?
8
Chapter 3: Resource Allocation in Competitive Markets II
11-13
9
Explain price elasticity of demand and income elasticity of demand.
14
10 A government is proposing to increase the tax on petrol. Examine the
14
relevance of price elasticity of demand and income elasticity of demand
for this proposal.
11 Assess the relevance of elasticity concepts in explaining the effects of the
15-16
worldwide recession caused by the 911 terrorist attacks on the airline
industry.
12 Chapter 4: Microeconomic Problems: Market Failure
17-18
13 Policies on Pollution and Evaluation Summary
19-21
14 Policies on Pollution and Congestion caused by Cars Summary
22-23
15 Chapter 5: Government Intervention in the Market I
24
16 Chapter 6: Firms and How They Operate I
25-30
17 Discuss whether rising costs limit the size of firms over time.
31
18 Banking Merger in Singapore Analysis
31
19 Chapter 7: Firms and How They Operate II
32-38
20 Discuss the view that the profit motive will always lead to a few large
39
firms dominating the market for each and every type of product.
21 Explain what is meant by productive and allocative efficiency.
40-41
22 A firm should be encouraged to maximize profits because this makes it
42
efficient. Discuss whether this argument is true for a firm operating in an
imperfect market.
23 Distinguish between monopolistic competition and oligopoly.
43
24 Explain why oligopoly is a common market structure in many economies.
44
25 Explain why governments throughout the world have been involved in
45
the supply of services such as electricity.
26 Chapter 8: Government Intervention in the Market II
46-48

Chapter 1: Scarcity, Choice and Opportunity Cost

1. Introduction
! Study of the use of scarce resources to satisfy unlimited human wants
! Wants: things people would consume if they had unlimited income
! Resources: inputs to produce goods and services
! Scarcity exists due to unlimited wants + worn out goods + newer goals
! Positive (can be checked by facts) vs. normative (statement of value)

2. Factors of Production
! Land: productive resources supplied by nature
! Labour: human effort directed to the production of goods and services
" Supply: number of workers + average number of hours each worker is
prepared to offer
" Specialisation
# Dexterity, greater use of machinery and more sophisticated
production techniques
# Monotony, loss of craftsmanship, increased risk of structural
unemployment
! Capital: man-made resource used in further production
" Involves postponing present consumption
! Entrepreneurship: takes risk of being in business
! Information: data for the basis of knowledge-based economy

3. Opportunity Cost
! Real cost in terms of the next best alternative foregone
! Calculating opportunity cost requires time and information
! Opportunity cost may vary with circumstance
! Economic rent: difference between what is earned and what could have been
earned
! Used in specialization and trade

4. Production Possibility Curve
! Maximum attainable combination of two goods and services that can be produced in
an economy, when all available resources are used fully and efficiently, at a given
state of technology
! Assumptions: fixed amount of resources, factors fully and efficiently employed,
technology fixed, time period give, 2-product model
! Fully: using all resources available
! Efficiently: do as many things you can with the resources used
! Scarcity: unattainable combinations outside PPC + society has to choose among
combinations of 2 goods
! Shift: quantity and quality of resources (think FOP) + technology skewed?
! Choice between instant gratification and improving economy in the future
2

 Wheat


*Draw dotted line to show comparison

between 2 countries with a common

yardstick





0
Cloth



5. The Marginalist Principle
! Consume till MPB = MPC: cost of producing an additional unit of good = benefit of
consuming an additional unit of good
! For the price mechanism to work, information need not be known with perfect
accuracy by every individual acting in the marketplace: dependent on marginal
buyers who keep suppliers on their toes

6. Efficiency
! Static efficiency: how much output can be produced now from a given stock of
resources at a given point in time
! Dynamic efficiency: changes in the amount of consumer choice available in markets
together with the quality of goods and services available
! Productive efficiency: absence of waste in the production process = minimizing the
opportunity costs for a given value of output
! Allocative efficiency: society produces and consumes a combination of goods and
services that maximizes its welfare
! Distributive efficiency: goods and services produced to those who want or need
them

Explain two ways in which an economy might move from a point within its PPC to a
point on it. [10m]

Introduction
Define PPC

Good X

A: resources not fully utilized

underemployment and

unemployment

B


B: efficient use of resources full

A
employment



Good Y
O

Body
A. Increase employment of resources
! Lower wages to be more competitive may be enticed to produce more goods
! Fiscal policy: increase government spending eg. circle line multiplier effect
! Monetary policy: lower interest rate firms borrow more, increase investment

B. Increase efficiency in use of resources
! Pay based on productivity: but only for jobs where output can be measured
(factory workers)
! Reallocate resources to more efficient uses
! Retraining

Discuss the most effective economic policies to move the PPC outwards. [15m]

Introduction
Outward shift: increase in productive capacity sustain economic growth over long run

Body
A. Labour
! Increase birth rate but difficult to do so in developed countries female labour
force participation + need lots of incentives
! Education and training but takes long time and does not necessarily yield results
! Foreign talent through tax incentives

B. Capital
! MNCs investment (machines) + learn their technological knowledge
! Invest in r+d

C. Entrepreneurship
! Incentives and subsidies to start businesses

D. Land
! Reclamation

Conclusion
Depends on which country
Eg. For USA: encourage capital goods, less consumption goods. For China:
entrepreneurship

What is meant by the basic economic problem of scarcity? [12m]

Introduction
Scarcity scare resources, unlimited wants

Body
Scarcity choice opportunity cost

1) Individual: time; consumer; how to maximize use of limited resources more labour /
more machines

2) Firm: least-cost combination of resources in order to maximize profits

3) Government: choice between competing projects; cost-benefit analysis

4) Economy: problem of how to allocated scare resources efficiently best illustrated by
the PPC


Good X


E


6


4



O
5 6
Good Y

(Brief) Implications:
! Trade as a solution to alleviate scarcity
! Trade-off between consumer goods and capital goods
! What (how scarcity affects decision-making of an economy), how much, for
whom and what to produce (market system)

Discuss whether economic growth solves the problem of scarcity. [13m]

Introduction
Economic growth increase in national income generally get to consume more goods
and services

Body
1) Increase in quantity and quality of resources increase in productive capacity
! Labour: due to reduction in unemployment and underemployment
! Skills and educational level
! Land
! Capital stock: most effective way to alleviate problem of scarcity more capital
economy produces in one period, more output capital can produce in the next to
satisfy wants in society

2) Technological improvement increase in productive capacity: better and new
methods of producing goods
! R + d technological breakthrough new products create more wants

3) Increase in income consumers able to satisfy wants
! But with greater affluence, people have more wants due to advertising and
promotions luxury goods of the past may become necessities

4) Supply limited
! Demand accelerating China / India economic growth
! Crude oil important as it is a source of fuel
! Eg. land in Singapore
! But technological improvements allow society to make use of renewable
resources as sources of energy
! But more wants created

5) Equity in distribution
! Economic growth does not guarantee a reduction in income gap
! Corruption, food shortages

Chapter 2: Resource Allocation in Competitive Markets I

*Assumption: Many buyers and sellers such that no single buyer / seller can exert
control over market price (price takers)

1. Demand Theory
! Demand: amount that consumers are willing and able to purchase at each given
price over a given period of time
! Demand curve slopes downwards
" Income effect: effect of change in real income resulting from change in price
of good
" Substitution effect: effect of change in price on quantity demanded arising
from consumer switching to, or from, alternating products
! Determinants
" Price
" Taste: education, culture, age group, health scares
" Interrelated goods: substitute vs. complement
" Population: absolute change, change in composition
" Seasonal changes: climate, festival
" Expectations of the future: future changes in price / income
" Real disposable income: changes in taxes / money income
" Redistribution of income
! Consumer surplus: difference between maximum amount consumers willing to pay
for a given quantity of good and what they actually pay

2. Supply Theory
! Supply: quantity of a good or service producers are willing and able to offer for sale
at each given price over a given period of time
! Determinants
" Price
" COP: change in price of factor inputs
" Other prices: joint / competitive supply
" Innovation: lower production costs
" Natural factors: climate, unexpected events
" Government policies: indirect taxes, subsidies
" Number of sellers
! Producer surplus: difference between amount received by producers and minimum
amount they are willing and able to accept for the supply of a commodity

3. Market Equilibrium
! Buyers and sellers satisfied with current combination of price and quantity bought or
sold, and are under no incentive to change their present economic actions

!
!

Adjustment to equilibrium
" Below equilibrium
# Shortage consumers compete for goods, bidding up prices price
increases, quantity supplied increases shortage eliminated market
settles at equilibrium
" Above equilibrium
# Surplus - producers reduce prices to get rid of stocks increase sales
and decrease production price falls, quantity demanded increases,
surplus eliminated market settles at equilibrium
Shifts in supply and demand: consider individual effects on price and quantity then
sum up
Interrelated demand and surplus
" Joint / competitive / derived demand
" Joint / competitive supply

4. Case Study
! When asked to explain how a group of people intend to affect a certain market,
bring in limitations
" Elasticity of demand
" Responses of other firms / groups of people
! Analyse theoretically first, then see how and why the data fits / does not fit the
theory
! Desirability: consider for whom: producer, consumer, society
! Effectiveness: limitations, long run vs. short run

A manufacturer wishes to sell more of his product. How may he try to achieve his aim?
[12m]

Introduction
Sell more only considering equilibrium quantity increase demand / supply
Effect: long run vs. short run

Body
1) Increase demand: explain effect on quantity demanded
! Advertising and promotion: create product differentiation and brand loyalty
" Competitive market: other firms will do likewise as they fear losing market
share
" Huge funds need to be devoted increase COP reduce profits
# If firm passes cost increase to consumers in terms of higher prices
fall in quantity sold assuming demand elastic total revenue falls
# But unable to increase price in competitive market firms may
engage in price wars
# But in long run if campaign successful in altering peoples taste and
preference rise in quantity sold
! Expanding number of markets: go regional / global
" Easier to penetrate markets where demand for product more price elastic
# Increase supply fall in price more than proportionate rise in
quantity demanded
! Improve quality of product / increase product differentiation through better
sales service / improved packaging
" Effect of money spent for r+d on
# Costs then price of product
# Market share in long run (increase)
! Deliberate attempt to reduce price of good through discounts
" Price elasticity of demand
" How long discount can be sustained without eroding profits

2) Increase supply: explain effect on quantity demanded
! Investment in r+d
" Lower COP, more efficient production methods, better quality products
! Raising productivity through greater specialization and better labour-capital
combination
! Sourcing cheaper sources of raw materials
! Evaluation
" Reduces price may conflict with profit maximization
" More effective strategy if selling product that is price demand elastic mass
produce reap EOS lower prices increase sales volume more than
proportionately

10

Chapter 3: Resource Allocation in Competitive Markets II

1. Price Elasticity of Demand
! Measure of degree of responsiveness of quantity demanded of good to a change in
its price, ceteris paribus
! Coefficient: sensitivity of consumers to price changes
! Negative: inverse relationship between price and quantity demanded
! Determinants
" Availability of substitutes
" Necessities vs. luxuries
" Proportion of income
" Time period: longer switch to substitutes more price elastic
! Usefulness
" Government taxation policies: raise revenue, discourage consumption
" Firms pricing policy
" Effectiveness of trade unions: can ask for higher wages if demand for product
is price inelastic
" Price stability: prices more volatile if demand more price inelastic when
supply shock

2. Income Elasticity of Demand
! Measure of degree of responsiveness of demand of good to change in consumers
income, ceteris paribus
! Coefficient
" Negative: inferior good
" Positive: normal good
# Less than one: necessities
# More than one: luxuries
! Usefulness
" Production plans: boom vs. recession
" Targetting different income groups: segment market

3. Cross Elasticity of Demand
! Measure of degree of responsiveness of demand of good to change in price of
another good, ceteris paribus
! Coefficient
" Negative: complement
" Positive: substitute
! Usefulness
" Effects on products demand when faced with change in price of rivals
product
" Strong complements can sell jointly

11

4. Price Elasticity of Supply

! Measure of degree of responsiveness of quantity supplied of good to a change in its
price, ceteris paribus
! Positive: direct relationship between price and quantity supplied
! Determinants
" Time period: longer supply more price elastic because possible to change
anything
" Factor mobility
" Number of firms: more supply more price elastic
" Stocks and spare capacity: more can produce more supply more price
elastic
" Length of production period: shorter supply more price elastic
! Usefulness
" Taxation: incidence
" Price stability

5. Government Policies
! Taxation / subsidies
" Demand more price inelastic higher incidence
# Incidence: distribution of burden between consumers and sellers
! Minimum price
" Protect income of producers
" Creates surplus for future shortages
" Financing annual surpluses burden on taxpayers not good in long run
" Cushion inefficiency
" New producers attracted increase surpluses unless government has
measures to increase demand
! Maximum price
" Lower-income consumers to afford necessities
" Protect consumers
" Allocation of goods may be biased
" Black market, especially during war time
" Government can encourage supply by drawing on past surpluses, giving
subsidies and tax relief, reducing demand by controlling income

6. Case Study
! Note difference between elasticity of the product and the elasticity of the final
product (which involves the use of the product)
! Note difference between less inelastic and more elastic
! When asked how a strategy might affect a company, consider effect on total
revenue then profits

12

7. Essay
! Limitations to using elasticity concepts to explain price changes
" Elasticity concepts are static need to relax ceteris paribus assumption in
reality simultaneous changes occur need to consider relative magnitudes
of changes in demand and supply
" Coefficients of elasticity mere estimates
" Consumers not homogenous group
# Among high-income earners, there are the yuppies seeking the high
life and are likely to be more price and income sensitive compared to
foreign investors who would consider socio-political factors
# May not consider some goods as substitutes

13

Explain price elasticity of demand and income elasticity of demand. [10m]

! Definition
! Formula
! Sign
! Coefficients: range of values for elastic / inelastic
! Examples with their estimated values

A government is proposing to increase the tax on petrol. Examine the relevance of
price elasticity of demand and income elasticity of demand for this proposal. [15m]

Introduction
Assume specific tax for simplicity
Uses of petrol: firms and commuters transportation
Normal good: income increase demand for cars increase demand for petrol increase

Body
1) Demand for petrol price inelastic: explain why
! Increase in indirect tax supply falls at given price supply curve shifts vertically
upwards by amount of tax
! Demand for petrol inelastic fall in quantity demanded less than proportionate
! Relevance: need high tax if government wants to reduce consumption to desired
level

2) Income elasticity of demand less relevant because it is due to changes in income tax
on petrol affects price directly, not income
! Government likely to be less successful if they increase tax on petrol in period of
economic boom
! Boom: incomes rise demand for cars (luxury good) increase by more than
proportionately derived demand increase demand for petrol

14

The terrorist attack on New York on 11 September 2001 caused a worldwide recession
and an increased fear of flying, both of which severely affected the demand for travel
by air. This led to the closure of some of the major airlines in the world.

Assess the relevance of elasticity concepts in explaining the effects of these events on
the airline industry. [15m]

Body
1) Price elasticity of demand
! Definition
! When supply of airlines fell due to closure of major airlines price expected to
increase quantity demanded fall by more than proportionate total revenue
fall
! Relevance
" Airlines should expect that reducing supply causing a rise in price can lead to
a fall in total revenue
" But the demand for travel for business is likely to be inelastic. So price
increase less than proportionate fall in quantity demanded total revenue
increase
" Effect on total revenue depends on size of business market vs. holiday
makers
" Due to the ceteris paribus assumption, the above will only take place if other
factors remain constant. In this context, incomes have changed causing
demand curve to shift total revenue fall

2) Income elasticity of demand
! Definition
! Air travel luxury good for most, necessity for business travelers
! Relevance
" Recession fall in income fall in demand fall in total revenue
" Implication: individual airlines need to reduce price / engage in non-pricing
strategies to increase market share

3) Cross elasticity of demand
! Definition
! Potential substitutes: train / coach / ship
" Degree of substitutability depends on the length of flight
# Long haul flights: weak substitutes especially for business travelers
# Short distance: stronger substitutes
! If another airline (eg. Qantas) reduces price to increase market share fall in
demand for a particular airline (eg. SIA) SIA reduces price price war may not
cover costs erode profits
" Budget airlines also pose as competition

15

Airlines close down routes / less schedules fall in supply increase price
" Demand inelastic: long haul flights no close substitutes total revenue
increase
" Demand elastic: short distance flights switch to trains / coaches total
revenue falls

4) Price elasticity of supply
! Definition
! Fall in price fall in quantity supplied
! But short run: supply price inelastic less than proportionate fall in quantity
supplied
! Reasons
" Labour: need time to retrench / reallocate labour to other departments
" Flight schedule / routes: need time to deliberate which routes / schedules to
close choose the unprofitable / lowest passenger volume

Conclusion
Cannot look at each value separately because in real world many variables change at the
same time

16

Chapter 4: Microeconomic Problems: Market Failure

1. Market Failure
! Scarce resources need to allocate resources efficiently objective: maximize
societys welfare (social optimality)
" MSB = MSC: benefit to society from one additional unit of good = cost to
society of producing one extra unit of good
! Ways to allocate resources
" Total government intervention
" Free market (based on price mechanism)
" Mixed economy (free market with some government intervention)
! Free market economy
" Private ownership of resources + individual decision-making guided by self-
interest
" Price serves as signal for resource allocation
" Automatic working of supply and demand spontaneity allocative
efficiency
" Equilibrium where demand = supply: maximization of consumer and
producer surplus
" Assumes no externalities + perfect competition
! Market failure occurs when
" Allocative inefficiency: externalities / public goods, imperfect competition
" Inability of market to achieve social objective eg. income equity

2. Externalities
! Cost / benefit on a third party not involved in the consumption / production of good
! Negative
" Types: industrial pollution, pollution and congestion from vehicles, demerit
goods eg. cigarettes
# External cost: second-hand smoke health problems, fire hazard,
environmental cost littering, anti-smoking campaigns money
comes from taxpayers who largely do not smoke
" To tabacco company: profit-maximising private producer: MPB = MPC
" To society: to attain social optimality: equilibrium level MSB = MSC = MPC +
MEC
" Overproduction: deadweight loss
! Positive
" Types: merit goods eg. healthcare, education
# External benefit: higher standard of living of everyone because of
highly-skilled jobs
" Under-production by free market: deadweight loss
! Because of partial market failure, government intervention comes in

17

3. Public Goods
! Non-excludable: impossible / costly to exclude non-paying consumers from receiving
the good
! Non-rivalrous: consumption by one person does not reduce amount available to
others
! Eg. National defense
! Free rider conceal demand private producer cannot gauge demand will not
produce non-production in free market total market failure
! Government provision necessary since public goods are socially desirable and largely
indivisible

4. Inequality
! Represented by the Lorenz Curve / Gini coefficient
! Singapore: 0.485 in 2007
! European countries: 0.25 0.3
! Latin America and the Caribbean: 0.6
! Average worldwide: 0.4

5. Essay
! When asked to suggest new policies, consider whether it is possible / practical to
enact them
! Policies may be difficult to administer, and policing expensive
! Opportunity costs involved in attempted to control negative externalities
! Political implications eg. public satisfaction

18

Policies on Pollution and Evaluation Summary

1) Identify: Taxation

Explain:
Tax polluters per unit of MEC COP increases for private firms supply
falls from MPC to MSC by amount of MEC

Evaluate:
* Negative externality internalized by firm: incentive for firm to be more -
cost-effective to maximize profits / reduce pollution

* Provides revenue for government to finance other social and
community development projects

* Able to allow market to continue operating according to market forces
and reach state of equilibrium

x Requires accurate valuation of MEC / amount of pollution
- Over-valuation: output below socially optimal level, reducing
societys welfare / deters production affects economic growth
- Under-valuation: output still not brought to socially optimal level

x Difficult to apportion blame

x Effectiveness dependent on price elasticity of demand: if highly price
inelastic, effect of tax on output ineffective unless tax very large / firm
able to move burden to consumers and get away scot-free

2) Identify: Quotas

Explain:
Ban production if pollution exceeds a certain limit limits MEC by
restricting output at socially optimal level

Clearly defined amount of pollution each firm can have

Evaluate:
* Able to control level of pollution in the country as a whole

X Does not allow price to equilibrate quantity demanded to quantity
supplied: firms may decide to produce less so they do not exceed the
maximum amount of pollution they can have (compare this to taxation)

X Difficult and tedious to gauge how much pollution each firm produces:
waste of resources and time on inspection

X Need vigilance and commitment of government

3) Identify: Legislation

Explain:
Force producers to bear costs of more proper disposal of industrial
wastes eg. antipollution equipment

19

Evaluate:





4) Identify:

Explain:

Evaluate:



5) Identify:

Explain:

Evaluate:



6) Identify:

Explain:

Evaluate:

x Difficult and costly: spend resources on inspection

X If chances of being caught and penalties are small, legislation
ineffective
X Need vigilance and commitment of government
X Not immediately effective because of bureaucracy involved in
establishing laws
X Lose voters leading to loss in power
Nationalisation
Government takes over the polluters firms and ensures production at
socially optimal output
x Waste of resources: opportunity cost to other projects because less
funds available
X Difficult to accurately valuate quantity demanded
X No competition: inefficient, no innovation
Campaign / advertisements to educate public
Raise awareness of pollution situation to public in hope they might do
something to curb problem
x Costs of these measures might outweigh benefits
X Duration needed before effects can be felt and there is no guarantee
that the campaign will be effective
X May be effective for only a short period of time because the public is
constantly bombarded by such campaigns that it is starting to lose its
intended effect
Subsidies
Subsidise purchase of antipollution equipment so that firms COP does
not increase that much by purchasing these equipment firms more
likely to buy the equipment than before
x Opportunity cost to other public projects
X No guarantee that firms will buy the equipment
X Firms need time to incorporate use of new equipment: but in the long
run probably mitigates the problem of pollution if firms use the
equipment

20

7) Identify:

Explain:


Evaluate:

Urban planning
Locate factories away from residential areas eg. Jurong Island
Greenery (to reduce impact)
x Merely shifting the pollution to another area does not solve the root
of the problem but reduces external cost since less people affected by
pollution
X Contentious as to whether greenery helps to reduce impact

Summation: Air pollution may not be due to the country itself, so need international /
regional cooperation

Can integrate a few policies for better results

21

Policies on Pollution and Congestion caused by Cars Summary

1) Identify: ERP per tax unit

Explain:
Restricts car usage (nowadays rely more on this policy)


Increases cost of car journey quantity demanded for car travel falls

Evaluate:
x Congestion in other areas / small roads


X Increase business cost pass to consumers

2) Identify: COE

Explain:
Restricts car ownership

Evaluate:
x Increasing affluence income elasticity of demand for cars


X Cannot stem peoples aspirations
X Needs vigilance and political will (in other countries, government might
not be able to have COE)

3) Identify: Efficient and affordable public transport

Explain:
Less pollution and congestion on roads

Evaluate:
x Not all countries have resources to build an effective public transport
system LDCs: no money, DCs: complex commuting patterns

X For it to be affordable, possibly need government to finance. Otherwise
if left to the private firm, they would want to charge more to maximize
profits.

4) Identify: Registration tax, annual road license

Explain:
Restricts car usage

Evaluate:
*May work if there is vigilance and commitment by government

5) Identify: Rebates for green vehicles eg. 20% off purchase price

Explain:
Lower price quantity demanded higher

Evaluate:
x Still not widely advocated

X May still be too expensive to afford

22

6) Identify:

Explain:

Evaluate:

Weekend cars
Restricts car usage
x Still not widely advocated
X People associate cars with prestige (eg. Americans love for SUVs)

23

Chapter 5: Government Intervention in the Market

1. Tacking Externalities
! Negative externalities [details on page 21-23]
! Positive externalities
" Subsidies: external benefit internalized (works like the tax)
# Can be easily implemented to bring about increase in production and
consumption
# Difficult to valuate external benefit generated
# High government expenditure high tax rates can subsequently
discourage investment in country
# Firms lose incentive to be more productively efficient inefficient
firms may survive
" Direct provision of merit goods
# Social justice: merit goods should be accessible to all and not
provided according to ability to pay
# Large positive externalities: eg. free healthcare combats spread of
disease
# Dependants: eg. free education to protect children from irresponsible
parents who fail to provide children quality education
# Ignorance: consumers may not realize how much they will benefit and
if they had to pay, they would rather go without it

2. Government Failure
! Allocative efficiency reduced following government intervention to correct market
failure
! Problem of incentives
" Imposition of high taxes can distort incentives
# High marginal tax removes incentive for people to work harder to
earn more
# Disincentive to produce and consume
" Desire by politicians to get elected: popular policies introduced (eg. minimum
wage law)
" Profit motive of private sector largely removed
! Problem of information
" Difficult to valuate external cost / benefit
" Difficult to accurately estimate level of consumer demand for product
! Problem of distribution
" Increase inequity
" Eg. tax on use of domestic fuel (kerosene in Indonesia) low income
households may feel greatest effect as tax on fuel oil may make life of poor
worse since they use proportionately more domestic fuel than others
! Bureaucracy and inefficiency: administrative costs; time lags
! Shifts in government policy: too frequent changes difficult for firms to plan ahead
24

Chapter 6: Firms and How They Operate I

1. Production in the Short Run
! Short run: at least one fixed factor
! Long run: period of time long enough for all factors to vary, except level of
technology, which varies in the very long run
! LDMR: as more units of a variable factor are applied to a given quantity of a fixed
factor, there comes a point beyond which the extra output from additional units of
the variable factor will eventually diminish
" Stage 1: TP increases at an increasing rate, MP rises due to specialization of
labour
" Stage 2: TP increases at a decreasing rate, MP falls, LDMR sets in due
inefficient use of fixed factor
" Stage 3: TP falls, MP falls
" MP = change in TP / change in L















2. Theory of Costs in the Short Run

Factor
Total Fixed Cost
Total Variable Cost
Marginal Cost
Definition Sum of all costs of Costs incurred for use of Additional cost incurred in
production do not vary variable factors like labour producing an extra unit of
with the level of output Varies directly with output in the short run
aka overhead costs
output level
while some inputs remain
Must be paid even
fixed
without production
MC = change in TC /
change in Q
Examples Rent of factory building, Raw materials, labour

interest
on
capital
invested in equipment

25

Graph

Average AFC: amount of fixed

curves
costs per unit of output
ATC
= AFC = TFC / Q
AVC
+
AFC

!
!
!

AVC: total variable costs
per unit of output
AVC = TVC / Q

Stage 1: AVC falls, AFC falls. Since AFC and AVC fall, ATC also falls
Stage 2: AVC rises, AFC falls. Since fall in AFC > rise in AVC, ATC still falls
Stage 3: AVC rises, AFC falls: Since fall in AFC < rise in AVC, ATC rises

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3. Objectives of Firms
! Profit-maximisation: equilibrium level of output since there is no tendency to change
" Before equilibrium level, MR > MC so firms want to produce more
" After equilibrium level, MR < MC and rational firms will not produce at this
output level
" Firm continues production as long as it can cover variable costs
! Motivation of owners vs. motivation of managers: separation of control and
ownership principal-agent problem: managers tend to pursue their alternative
goals while maintaining minimum level of profits to appease shareholders
! Revenue maximization: managers aim to maximize firms short run total revenue
! Long-run profit maximization: managers aim to shift cost and revenue curves so as
to maximize profits over some longer time period
! Growth maximization: managers may aim for expansion to maximize growth in sales
volume over time

4. Theory of Costs in the Long Run
! Returns to scale: measure of resulting change in output when all inputs are changed
in the same proportion (can be increasing, decreasing or constant)
! LRAC: lowest average cost for given level of output when all inputs are variable
! Minimum efficient scale: smallest plant size beyond which no significant additional
IEOS can be achieved
! IEOS: savings in costs that occur to a firm due to the firms expansion, and have been
created by firms own policies and actions
" Technical: concerned with production process
# Factor indivisibility economies: larger plant size makes it possible to
effectively use indivisible factors (combine harvesters, power
transmission: large and costly) raises average output and reduces
LRAC
# Specialisation of labour: simpler and repetitive jobs which require less
training + more efficient eg. car manufacturing
" Managerial: functional specialization by employing experts to increase
efficiency as a whole
# Greater use of existing staff
# Decentralisation of decision-making: increasing efficiency of
management because of faster flow of information within firm
distortions and delays of information avoided
" Commercial
# Bargaining advantage and accorded preferential treatment by
suppliers because they buy raw materials in bulk
# Bulk sales from bulk advertising and large-scale promotion

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" Financial
# Easier and cheaper to raise funds: given lower interest rate and larger
loans because better credit ratings and more collateral
# Raise capital through issue of shares to public who has more
confidence in reputed firms
" Risk-bearing
# Advantage in bearing non-insurable risks eg. conditions of demand for
final products and supply of raw materials
# Diversification of products and markets
# Diversification in sources of supply
" R+d
# Better quality products increased market share and demand
# Better methods of production more productively efficient lower
average cost
" Welfare: making workers feel they belong to the company more apt to
increase efficiency and productivity of company
IDOS
" Complexity of management
# Principal-agent problem
# Bureaucracy
" Strained relationships: impersonal no loyalty to firm apathy, strikes
EEOS: savings in costs that occur to all firms in an industry due to the expansion of
the industry
" Economies of concentration
# Availability of skilled labour: demand for labour large enough
special educational institutions / firms can collaborate to develop
training facilities
No lack of labour to employ because experts want to migrate
there eg. Silicon Valley
# Well-developed infrastructure to cater to that industry
# Reputation: builds up name which consumers associate with quality
encourages brand loyalty and steady clientele
" Economies of disintegration
# Subsidiary industries developed to cater to needs of major industry
Eg. car industry in Japan: range of firms specialize in
production of different inputs for car manufacturing provide
output at lower prices to main industry because specialization
allows subsidiary firms to produce at large scale enjoy EOS
# Process waste products into useful products and sell them to cover
COP
" Economies of information: publications help improve productivity of firms
(research and expertise)

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EDOS
" Increased strain on infrastructure: taxed to limits eg. congestion loss of
time and increased fuel consumption
" Rising costs of FOP: growing shortage of specific raw materials / skilled
labour

5. Growth of Firms
! Methods of growth
" Internal expansion: make more of existing product or extending range of
product when it builds a new bigger plant
" Merger
# Vertical integration: firms engaged in different stages of productive
process
Backward integration vs. forward integration
Eg. Starbucks merge with firm producing coffee beans wants
guaranteed access to raw materials
# Horizontal integration: firm takes over similar firm at same stage of
production in the same industry
Eg. Coffee Bean and Starbucks merge
Eg. DBS and POSB
Market domination
" Conglomeration
# Eg. bank taking over developing firm to build properties
# Diversify output

6. Survival of Small Firms
! Demand-side factors
" Nature of product
# Bulky and perishable goods: small, localized markets eg. fresh fish
# Variety preferred to standardization eg. fashion
# Specialised products: limited markets eg. highly specialized machines
" Prestige markets: limited by price eg. sports cars, luxury yachts
" Direct and personalized services eg. lawyers, doctors
" Geographical limitations: high transport costs for bulky products local
market rather than national market
! Supply-side factors
" DEOS set in early: optimum size of firm small
" Vertical disintegration: entire production process broken into series of
separate processes and different small firms perform each process
" Low BTE
" Lack of capital

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" Unwillingness to take greater risks

# Larger firm higher expenditure greater risk of investment
# Fear of future fall in price of final product: expansion of output
increase market supply excess supply lower prices and lower
profits
" Banding: small firms may band to gain advantages of bulk buying while still
retaining their independence
" Profit cycles: early stage of product cycle total demand for product low
" Non-profit maximization attitudes
# Owner values independence or wants to maintain control among
family members
# Contented with reasonable income from domestic market
# Unwilling to take increased risks associated with expanding into
foreign market

7. Case Study
! Factors: think long run vs. short run, demand-side vs. supply-side
! EOS lower LRAC able to reduce price
" Profits plough to r+d better quality products + further reduction in AC
" Block new entrants due to enormous FC less existing competitors
increase market share
! Always end EOS with AC
! If a particular industry is stated in the extract, try to give egs of EOS specific to the
industry

8. Essay
! Survival of small firms: for conclusion, use banding / small firms may want to merge
in the face of globalisation

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Discuss whether rising costs limit the size of firms over time. [15m]

Introduction
! Size: sales revenue / turnover, level of output, market share
! Over time long run firm no longer constrained by fixed factor

Body
1) Can limit
! Short run cost
" Reason: over-use of fixed factor, inefficient labour-capital combination
increase MC eventual increase in AC
" Increase costs fall in profits if total revenue is constant constrain firms
ability to expand

2) Will not limit
! Long run
" All inputs can vary firm can expand enjoy fall in LRAC due to internal EOS
(list 2 egs)
" Fall in LRAC fall in price to ward off competitors (erecting barriers to entry)
increase profits plough into r+d better quality products + if yields results
further fall in AC due to better production methods
" Size of firm determined by demand for firms product if firm making
supernormal profits can still expand in size even if cost increases eg.
monopoly selling unique products

Conclusion: However, size of firm over time constrained by MES (list 1 eg of internal
DOS). MES huge eg. electricity / water compared to MES limited eg. fashion.

Banking Merger in Singapore Analysis

Why merge?
! Face competition from foreign banks Singapore wants to expand beyond our
shores: big enjoy EOS fall in AC can compete with foreign banks
! Core part of Singapore economy 1997 Asian financial crisis big $ stable

Why should not merge?
! Possible monopoly power
" Increase price
" Quality of service
# Reduction / removal of familiar products and services affects
consumer satisfaction
# Neglect lower-income group
! Retrenchment
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