Firms, costs, growth and competition

Pearson Edexcel International A Level Economics (WEC13), specification Issue 2, June 2018. This topic covers spec sections 3.3.1–3.3.3 in full: types, sizes and growth of businesses and business objectives (3.3.1); revenue, costs and profits with economies of scale (3.3.2); and the whole market-structures spectrum from perfect competition to contestability (3.3.3) — 57 lettered objectives. The demand side stays on the shared model (AR: $P = 70 - Q/2$), and the cost machinery is built from one original table so every figure cross-checks.

Must-know for this topic:

Business types 类型 (3.3.1.1): private sector organisations (owned by shareholders or proprietors for profit); state-owned enterprises in the public sector; for-profit versus NOT-FOR-PROFIT organisations (surplus reinvested, not distributed); co-operatives (owned by members, one member one vote); and joint ventures (two firms pool resources for one project, sharing risk and control). Sizes run from SMEs 中小企业 (small and medium enterprises) to large corporations (3.3.1.2a). Businesses grow ORGANICALLY (reinvested profits, new products, new outlets) or by MERGER and TAKEOVER (3.3.1.2b): FORWARD vertical integration buys a customer stage (a brewer buys pubs); BACKWARD vertical buys a supplier stage (the brewer buys a hop farm); HORIZONTAL integration buys a rival at the same stage; CONGLOMERATE integration buys an unrelated business. Advantages: vertical secures supply or outlets and internalises mark-ups; horizontal cuts costs and market rivalry; conglomerate spreads risk. Disadvantages: integration is costly, cultures clash, and size invites diseconomies and regulation (3.3.1.2c). Growth constraints: the size of the market, access to finance, the owner's objectives, and government regulation and bureaucracy (3.3.1.2d); firms stay small where markets are local, finance is thin, owners prefer control, or rules bite — and grow where the reverse holds (3.3.1.2e). Growth affects businesses (market power, scale), workers (jobs, but restructuring) and consumers (lower prices versus less choice) (3.3.1.2f); Demergers 分拆 split conglomerates back into focused units when coordination fails, with mirror effects on all three groups (3.3.1.2g).

Objectives (3.3.1.3): profit maximisation 利润最大化 ($MR = MC$); REVENUE MAXIMISATION (revenue max where $MR = 0$ — here $Q = 70$, $P = 35$, exactly the topic-1 unitary-PED point); SALES VOLUME MAXIMISATION (largest output subject to covering costs); and BEHAVIOURAL theories — SATISFICING, where managers aim for a satisfactory result rather than the maximum (Herbert Simon). The DIVORCE OF OWNERSHIP FROM CONTROL makes objectives contestable: shareholders (principals) want profit; managers (agents) run the firm daily and may prefer growth, pay or quiet lives — the principal-agent problem 委托代理问题 (3.3.1.3b). Formulae: profit max at $MR = MC$; revenue max at $MR = 0$; sales-volume max at $AR = ATC$ (normal profit constraint) (3.3.1.3c).

Revenue (3.3.2.1): $TR = P \times Q$, $AR = TR/Q$ (the demand curve) and $MR = \Delta TR/\Delta Q$; when the demand curve is a straight line, MR has TWICE its slope — AR $P = 70 - Q/2$ gives MR $P = 70 - Q$. PED links to revenue: with $|PED| > 1$ a price cut RAISES revenue (MR positive), with $|PED| < 1$ it lowers it — at Q = 40, price 50, TR = 2000 and MR = 30 (positive, so still in the elastic range).

Costs (3.3.2.2): the SHORT RUN has at least one fixed factor, and the law of diminishing returns 收益递减规律 makes marginal product fall as more variable input is added to it — which is why marginal cost eventually rises and the cost curves take their U-shapes. The original table (TFC = 12): TVC for Q = 1…9 runs 5, 9, 12, 14, 17, 21, 26, 32, 39, so MC runs 5, 4, 3, 2, 3, 4, 5, 6, 7, falling while specialisation dominates and rising once diminishing returns bite. $TC = TFC + TVC$; per unit, $ATC$ and $AVC$ are U-shaped and $MC$ cuts EACH at its minimum: AVC is minimised at $Q = 5$ (3.4) and ATC at $Q = 7$ (5.43). Marginal product and marginal cost are mirror images (high MP → low MC); average product mirrors AVC; total product mirrors TC; and in the LONG RUN all factors are variable, so only then can the whole cost structure change (3.3.2.2d).

Profits and losses (3.3.2.4): normal profit 正常利润 is the minimum return keeping the entrepreneur in the industry — an opportunity COST, included in ATC; supernormal profit 超额利润 is anything above it ($P > ATC$); a LOSS is $P < ATC$. The firm should SHUT DOWN in the short run only when $P < \min AVC = 3.4$: below that, revenue fails to cover even variable costs; between AVC and ATC it trades at a loss smaller than its fixed costs, which are sunk in the short run. In the long run the exit point is $P = \min ATC = 5.43$.

The long-run average cost curve (LRAC) falls with INTERNAL economies of scale, flattens at the minimum efficient scale 最小有效规模 (MES) — the smallest output at which lowest average cost is achieved — and rises with diseconomies (3.3.2.3a–b). Internal economies (inside the firm, 3.3.2.3d): FINANCIAL (cheaper borrowing), TECHNICAL (larger plant), MANAGERIAL (specialist managers), MARKETING (spread advertising), PURCHASING (bulk discounts), RISK-BEARING (diversified products). EXTERNAL economies (industry-wide, 3.3.2.3e): availability of skilled labour, access to transport links, sharing knowledge. Diseconomies (3.3.2.3f): communication problems, coordination problems, and X-INEFFICIENCY (costs drifting above the achievable minimum for lack of competitive pressure).

The four efficiency concepts (3.3.3.1): ALLOCATIVE efficiency ($P = MC$ — price reflects marginal cost to society); PRODUCTIVE efficiency (output at minimum ATC); DYNAMIC efficiency (investment and innovation over time, funded by profits); and X-INEFFICIENCY (wasteful production above the cost floor). Each market structure scores differently — perfect competition is allocatively and productively efficient in the long run but dynamically weak; monopoly may be dynamically efficient but is rarely allocatively so. The n-firm concentration ratio 集中度 (3.3.3.2): with shares 40, 25, 15, 10 and 10, the four-firm ratio is $CR4 = 40 + 25 + 15 + 10 = 90\%$ — a concentrated market; its significance: high ratios flag market power (but miss foreign competition and contestability).

Perfect competition 完全竞争 (3.3.3.3): many small firms, identical products, perfect information, free entry and exit — each firm is a PRICE TAKER, so $P = AR = MR$; short-run profit maximisation at $MC = MR$, long-run entry driving price to $P = \min ATC$ — only normal profit, with productive AND allocative efficiency ($P = MC$) in the long run; the short-run shutdown is $P < AVC$.

Monopolistic competition 垄断竞争 (3.3.3.4): many firms, DIFFERENTIATED products — physically (features), by marketing (advertising, packaging) or distribution (shop, online, telephone) — so each faces a downward-sloping demand curve: short-run supernormal profits attract entry, which in the long run drives profits to normal while price sits above MC (excess capacity, not allocatively efficient).

Oligopoly 寡头垄断 (3.3.3.5): few large INTERDEPENDENT firms behind barriers to entry — economies of scale, LIMIT PRICING (pricing below the profit-maximising level to deter entry), patents, branding, SUNK COSTS and legal barriers (3.3.3.5b). Interdependence brings strategic behaviour: the simple two-firm, two-outcome game below shows why collusion is fragile — defecting is each firm's dominant strategy, so both end at the Nash equilibrium 纳什均衡 (2, 2) although collusion (4, 4) pays both better (3.3.3.5c). Collusion can be formal (cartels 卡特尔) or tacit (PRICE LEADERSHIP); PRICE WARS break out when the discipline fails. Collusion benefits producers (higher profits) at the cost of consumers (higher prices), workers (uncertain) and governments (deadweight loss, illegality) (3.3.3.5d). Price competition includes price wars, PREDATORY PRICING (below cost to drive out entrants) and limit pricing (3.3.3.5e); NON-PRICE competition runs through advertising and branding, quality, endorsement, product placement and after-sales service (3.3.3.5f) — each with costs and benefits to firms, consumers, employees and suppliers (3.3.3.5g).

Monopoly 垄断 (3.3.3.6): one seller behind barriers; profit maximisation where $MR = MC$. On the shared model with MC $P = 10 + Q/2$: $70 - Q = 10 + Q/2$ gives $Q_m = 40$; price on the AR curve is $P_m = 50$; with $ATC = 30$ at that output, supernormal profit is $(50 - 30) \times 40 = 800$ per day. Against the competitive benchmark ($P = MC$: $Q_c = 60$, $P_c = 40$) the monopoly raises price by 10, cuts output by 20 and creates a deadweight loss of $\tfrac12 \times 20 \times 20 = 200$ (3.3.3.6c–d). A natural monopoly 自然垄断 has falling average costs over the whole market (one network is cheapest) — its implication: regulate rather than fragment (3.3.3.6e). third-degree price discrimination 三级价格歧视 (3.3.3.6f) needs market power, separable groups with different PEDs, and no resale: charging each group its profit-maximising price raises producer surplus, benefits price-elastic groups with lower prices and harms inelastic groups (3.3.3.6g). Monopoly is productively and allocatively inefficient but may be dynamically efficient (3.3.3.6h).

Monopsony 买方垄断 (3.3.3.7): ONE buyer facing many sellers — conditions: the buyer dominates the input market (a single big employer in a town). It pushes the input price BELOW the competitive level: the firm gains (lower costs, higher profits) while suppliers or EMPLOYEES lose (lower wages), and output falls — consumers may gain from lower prices if cost savings are passed on (3.3.3.7b).

Contestability 可竞争性 (3.3.3.8): a market is contestable when ENTRY AND EXIT are cheap — the key is SUNK COSTS: with none, hit-and-run entry disciplines incumbents. Implications: even a single incumbent keeps profits near normal and prices near competitive levels, often through LIMIT PRICING (3.3.3.8a–b). Contestability benefits consumers (low prices, choice) and disciplines firms; its costs fall on incumbents' shareholders, and low sunk costs mean little commitment to quality investment (3.3.3.8c–d).

Extract. In January 2022 Microsoft, which makes the Xbox games console, agreed to buy Activision Blizzard, the maker of Call of Duty, for about US$69 billion, the largest deal in the history of video games. Rival Sony argued that Microsoft could make popular games exclusive to Xbox. In April 2023 the UK's Competition and Markets Authority (CMA) blocked the deal, mainly because Microsoft already had a large share of the young cloud-gaming market and could control access to Activision's games there. Microsoft offered 10-year agreements to keep Call of Duty on rival consoles, and sold the cloud-streaming rights to Activision's games outside Europe to the French firm Ubisoft for 15 years. The CMA approved the changed deal in October 2023.

Table: illustrative shares of a games console market (%)

Questions

• (a) Using the table, calculate the three-firm concentration ratio and identify the market structure it suggests. [2]
• (b) Explain why Microsoft's purchase of Activision could be described as vertical integration. [4]
• (c) With the help of a diagram, explain why less competition could lead to higher prices for consumers. [6]
• (d) Examine two reasons why competition authorities investigate large mergers. [8]
• (e) Evaluate whether the CMA was right to approve the changed deal. [12]

Model answers

(a) $CR_3 = 45 + 30 + 20 = 95\%$. Three firms supply nearly the whole market: a highly concentrated oligopoly.

(b) Vertical integration joins firms at different stages of the same production chain. Activision makes games (content), while Microsoft owns the platform on which games are sold and played (the Xbox and its cloud and subscription services). Buying a supplier of an input to its own platform is backward vertical integration. (It also has a horizontal element, because Microsoft already published games.)

(c) Use the monopoly diagram: a firm with market power faces a downward-sloping demand (AR) curve, with MR below it, and maximises profit where MR = MC. Compared with a competitive market, where price equals MC, output is lower and price higher, and there is a deadweight loss. If a merger lets Microsoft make key games exclusive, rivals' consoles become less attractive, Microsoft's demand becomes less elastic and its market power grows, so prices for consoles, games or subscriptions could rise.

(d) To protect consumers from higher prices and less choice: a merged firm with a large market share can raise prices, and if it controls an important input (a popular game) it can foreclose rivals. To protect innovation and future competition: in a new market such as cloud gaming, a dominant firm can stop new rivals from growing, so the market never becomes competitive. Evaluation: mergers can also bring benefits, such as economies of scale and more investment, so authorities must weigh these against the risks; it is hard to predict how young markets will develop.

(e) For approval: the remedies dealt with the main concern. Selling the cloud rights to Ubisoft meant Microsoft did not control access to Activision's games in cloud gaming, and the 10-year agreements kept Call of Duty on rival consoles. The merger may bring economies of scale, more investment in games and wider availability through subscription services. Other authorities (the EU) also approved the deal with remedies.

Against approval: behavioural remedies such as access agreements must be monitored and may be hard to enforce; they end after 10 or 15 years. The merger still increases concentration in game publishing, and Microsoft could favour its own platforms in subtle ways (timing, features). The deal may encourage other large technology firms to buy rivals, reducing competition over time.

Judgement: the CMA's decision was reasonable, because the remedy targeted the specific risk it had identified (control of cloud gaming) through a structural change (the rights sale) rather than only promises. But its success depends on how cloud gaming develops and whether the agreements are enforced; the authority should review the market before the agreements end.

What examiners reward: a correct concentration ratio with the market structure named, clear use of vertical or horizontal integration, a monopoly diagram used to explain the price effect, examined reasons with counter-points, and a judgement that uses the extract's remedies.

• Business types (private, state, not-for-profit, co-operatives, joint ventures); SMEs vs large corporations; organic growth and the four integrations with advantages and disadvantages; growth constraints; why firms stay small; growth and demerger effects on businesses, workers, consumers (3.3.1).
• Objectives: profit max (MR = MC), revenue max (MR = 0, Q = 70 here), sales-volume max, satisficing; the principal-agent problem and the divorce of ownership from control (3.3.1.3).
• TR/AR/MR with the twice-the-slope rule and the PED link (3.3.2.1).
• Short-run cost curves from diminishing returns: the table with MC 5→2→7, AVC min 3.4 at Q = 5, ATC min 5.43 at Q = 7; the four mirror relationships; normal/supernormal profit; shutdown and break-even rules (3.3.2.2, 3.3.2.4).
• LRAC, MES, six internal and three external economies, three diseconomies (3.3.2.3).
• Allocative, productive, dynamic efficiency and X-inefficiency; CR4 = 90% calculation and significance (3.3.3.1–2).
• Perfect competition (price taker, LR P = min ATC, efficient), monopolistic competition (differentiation, excess capacity), oligopoly (barriers, the prisoners' dilemma with Nash (2, 2) vs collusion (4, 4), cartels, price leadership, price wars, predatory and limit pricing, non-price competition), monopoly (Qm 40, Pm 50, profit 800, DWL 200, natural monopoly, third-degree price discrimination) (3.3.3.3–6).
• Monopsony and contestability with sunk costs (3.3.3.7–8).

Boundary notes: WEC13 papers are 2 hours, 80 marks and draw on Units 1-2. Diagrams carry marks: label AR/MR/MC/ATC, mark Qm and Pm, shade the profit box and the deadweight triangle. Worked numbers are original and consistent.