Factors affecting investment

Investment is expenditure on capital goods – for example, new machines, offices,

new technology. Investment is a component of Aggregate Demand (AD) and also
influences the capital stock and productive capacity of the economy (long-run
aggregate supply)

Summary – Investment levels are influenced by:

1. Interest rates (the cost of borrowing)
2. Economic growth (changes in demand)
3. Confidence/expectations
4. Technological developments (productivity of capital)
5. Availability of finance from banks.
6. Others (depreciation, wage costs, inflation, government policy)

Main factors influencing investment by firms

1. Interest rates
Investment is financed either out of current savings or by borrowing. Therefore
investment is strongly influenced by interest rates. High interest rates make it
more expensive to borrow. High interest rates also give a better rate of return
from keeping money in the bank. With higher interest a rate, investment has a
higher opportunity cost because you lose out the interest payments.

The marginal efficiency of capital states that for investment to be worthwhile, it

needs to give a higher rate of return than the interest rate. If interest rates are
5%, an investment project needs to give a rate of return of at least 5% or more.
As interest rates rise, fewer investment projects will be profitable. If interest rates
are cut, then more investment projects will be worthwhile.
Evaluation
 Time lags. If a firm has started an investment project, a rise in interest
rates will be unlikely to change the decision. The firm will continue to finish
the investment. However, it will make them think twice about future
investment projects. Therefore changes in interest rates can take time to
have an effect.
 Other factors. Interest rates can be outweighed by economic conditions.
For example, in 2009, interest rates were cut from 5% to 0.5% – but
investment fell because of the deep recession and the unwillingness of the
banks to lend. It was cheap to borrow, but in these circumstances, this
wasn’t enough to encourage investment.
2. Economic growth

Firms invest to meet future demand. If demand is falling, then firms will cut back
on investment. If economic prospects improve, then firms will increase
investment as they expect future demand to rise. There is strong empirical
evidence that investment is cyclical. In a recession, investment falls, and recover
with economic growth.

Accelerator theory The accelerator theory states that investment depends on

the rate of change of economic growth. In other words, if the rate of economic
growth increases from 1.5% a year to 2.5% a year, then this increase in the
growth rate will cause an increase in investment spending as the economy is on
an up-turn. The accelerator theory states that investment is highly dependent on
the economic cycle.
3. Confidence
Investment is riskier than saving. Firms will only invest if they are confident about
future costs, demand and economic prospects. Keynes referred to the ‘animal
spirits’ of businessmen as a key determinant of investment. Keynes noted that
confidence wasn’t always rational. Confidence will be affected by economic
growth and interest rates, but also the general economic and political climate. If
there is uncertainty (e.g. political turmoil) then firms may cut back on investment
decisions as they wait to see how event unfold.

 Evaluation – Confidence is often driven by economic growth and changes

in the rate of economic growth. It is another factor that makes investment
cyclical in nature.
4. Inflation
In the long-term, inflation rates can have an influence on investment. High and
variable inflation tends to create more uncertainty and confusion, with
uncertainties over the future cost of investment. If inflation is high and volatile,
firms will be uncertain at the final cost of the investment, they may also fear high
inflation could lead to economic uncertainty and future downturn. Countries with
a prolonged period of low and stable inflation have often experienced higher
rates of investment.

 Evaluation – if low inflation is caused by a fall in demand and economic

growth – then this low inflation will not, of itself, be sufficient to boost
investment. The ideal is low inflationary and sustainable growth.
5. Productivity of capital
Long-term changes in technology can influence the attractiveness of investment.
In the late nineteenth century, new technology such as Bessemer steel and
improved steam engines meant firms had a strong incentive to invest in this new
technology because it was much more efficient than previous technology. If there
is a slowdown in the rate of technological progress, firms will cut back investment
as there are lower returns on the investment.

6. Availability of finance

In the credit crunch of 2008, many banks were short of liquidity so had to cut
back lending. Banks were very reluctant to lend to firms for investment. Therefore
despite record low-interest rates, firms were unable to borrow for investment –
despite firms wishing to do that.

Another factor that can influence investment in the long-term is the level of
savings. A high level of savings enables more resources to be used for
investment. With high deposits – banks are able to lend more out. If the level of
savings in the economy falls, then it limits the amounts of funds that can be
channelled into investment.

7. Wage costs
If wage costs are rising rapidly, it may create an incentive for a firm to try and
boost labour productivity, through investing in capital stock. In a period of low
wage growth, firms may be more inclined to use more labour-intensive
production methods.

8. Depreciation
Not all investment is driven by the economic cycle. Some investment is
necessary to replace worn out or outdated equipment. Also, investment may be
required for the standard growth of a firm. In a recession, investment will fall
sharply, but not completely – firms may continue with projects already started,
and after a time, they may have to invest in less ambitious projects. Also, even in
recessions, some firms may wish to invest or startup.

9. Public sector investment

The majority of investment is driven by the private sector. But, investment also
includes public sector investment – government spending on infrastructure,
schools, hospitals and transport.

10. Government policies

Some government regulations can make investment more difficult. For example,
strict planning legislation can discourage investment. On the other hand,
government subsidies/tax breaks can encourage investment. In China and
Korea, the government has often implicitly guaranteed – supported the cost of
investment. This has led to greater investment – though it can also affect the
quality of investment as there is less incentive to make sure the investment has a
strong rate of return.

Investment and Aggregate Demand

Readers Question: What are the effects of increased investment on aggregate
demand in the short term and the long term.
 Investment means capital expenditure (e.g. purchasing machines or
building bigger factory)
 Investment is a component of AD –  AD+ C+I+G+X-M.
 Investment spending takes about 15% of AD; it is not as significant as
consumer spending which is 61%.
If Investment increases, then ceteris paribus, AD will increase.Effect of
investment in the short-term

The increase in aggregate demand will lead to higher economic growth and
possibly inflation.
Multiplier Effect

If there is spare capacity in the economy, an increase in investment could cause

a knock on effect throughout the economy. The initial increase in investment
causes a rise in output and so people gain more income, which is then spent
causing a further rise in AD. With a strong multiplier effect, there may be a bigger
increase in AD in the long-term.
Effect on aggregate supply (long-run)

In the long term, an increase in investment should also increase productive

capacity and increase aggregate supply.

Therefore, investment can enable a more sustainable increase in AD. The

increase in capacity enables a sustained rise in AD without causing inflation. If
the economy is at full capacity and AD rises then there will be just inflation.

Effective investment can help increase the long-run trend rate of economic

growth.
 

Evaluation of the effects of higher investment

It depends on the economic circumstances. For example, if there was a
situation of falling house prices and lower consumer spending, increased
investment may be insufficient to increase AD. Also, at only 15% of AD, it is a
relatively small component and can easily be outweighed by domestic
consumption.
Investment only 15% of AD

The opportunity cost of investment. If an economy devotes a higher share of

GDP to investment, then in the short-term, this implies a lower share of GDP for
consumption. Investment is financed out of savings. Therefore, a shift to
investment could lead to lower consumption in short-term, though, if successful,
the investment can enable increased productive capacity in the long-term

This PPF curve shows a trade-off between consumer goods and capital goods
(investment) A move from A to B reduces consumption in short-term but
increases PPF in long-term

How effective is the investment? Different types of investment can give quite

different rates of return. For example, investment in the Sony MiniDisc proved
ineffective in boosting productive capacity as the technology was later obsolete.
Government investment can also vary in quality. For example, state-
supported investment in Concorde (super-sonic) jet had a poor rate of return and
the project was deemed unprofitable. However, public investment in improving
road network could help reduce congestion and improve long-term economic
growth.
Investment and the Rate of Interest
An explanation of how the rate of interest influences the level of investment in the
economy. Typically, higher interest rates reduce investment, because higher
rates increase the cost of borrowing and require investment to have a higher rate
of return to be profitable.

 Private investment is an increase in the capital stock such as buying a

factory or machine. (investment in this context does not relate to saving
money in a bank.)
 The marginal efficiency of capital (MEC) states the rate of return on an
investment project. Specifically, it refers to the annual percentage yield
(output) earned by the last additional unit of capital.
 If the marginal efficiency of capital was 5% and interest rates were 4%,
then it is worth borrowing at 4% to get an expected increase in output of
5%. (an effective profit margin of 1%)
Interest rates and investment

If interest rates rise from 5% to 7%, then we get a fall in the quantity of
investment from 100 to 80.

If interest rates are increased then it will tend to discourage investment because
investment has a higher opportunity cost.
 1. With higher rates, it is more expensive to borrow money from a bank.
2. Saving money in a bank gives a higher rate of return. Therefore, using
savings to finance investment has an opportunity cost of lower interest
payments.
If interest rates raised, firms will need to gain a better rate of return to justify the
cost of borrowing/using savings.

 Assuming inflation is zero, and interest rates are 5%. Then any investment
project would need an expected rate of return of at least greater than 5%.
If interest rates were 7%, then any investment project would need an
expected rate of return of at least greater than 7%, and therefore less
investment would occur.
Real interest rates and investment

For firms, they will consider the real interest rate – which equals nominal interest
rate – inflation.

 If inflation is 10% and nominal interest rates 9% – we have negative real

interest rates. Borrowing money is more desirable as inflation will make it
easier to pay it back.
 If inflation is 4% and nominal interest rates are 6%, we have real interest
rate of 2%
Elasticity of demand for investment

Interest rates are one important determinant of investment. However, it is not the
only factor, other factors include investor confidence, economic growth,
the willingness of banks to lend, accelerator theory, and state of technology.

In a liquidity trap, lower interest rates may have little effect on boosting levels of
investment. Therefore demand for investment becomes very interest inelastic.
In this case, a fall in interest rates from 5% to 0.5% have had only a very small
impact on increasing investment.

This happened during the great recession of 2009 when interest rates were cut to
0.5%, but the economy remained stagnant with little increase in investment. In
2009, the credit crunch meant that banks were unable or unwilling to lend.

Factors that determine investment apart from interest rates

 Investor confidence ‘animal spirits’ – mentioned by J M Keynes

 Economic growth. The accelerator theory states that investment is
influenced by rates of change in economic growth. signs of economic
recovery will lead to strong growth in investment.
  Availability of finance. If banks are willing to lend then investment will be
stronger. In a credit crunch, banks may cut back on lending and firms will
be unable to invest – even if they wanted to borrow for investment.
Interest rates and investment in practice

Causes of economic growth

27 October 2019 by Tejvan Pettinger

 Economic growth means an increase in real GDP. Economic growth

means there is an increase in national output and national income.
 Economic growth is caused by two main factors:
1. An increase in aggregate demand (AD)
2. An increase in aggregate supply (productive capacity)

See latest stats on economic growth

Demand-side causes
In the short term, economic growth is caused by an increase in aggregate
demand (AD). If there is spare capacity in the economy, then an increase in AD
will cause a higher level of real GDP.

AD= C + I + G + X- M

 C= Consumer spending
 I = Investment (gross fixed capital investment)
 G = Government spending
 X = Exports
 M = Imports
Graph showing increase in AD

1. Factors which affect AD

 Lower interest rates – Lower interest rates reduce the cost of borrowing
and so encourages consumer spending and firms to invest. Lower interest
rates also reduce mortgage payments and so increase the disposable
income of consumers.
 Increased wages. Higher real wages increase disposable income and
encourage consumer spending.
  Increased government spending (G). e.g. government investment on
building new roads or increased spending on welfare benefits, which
increase disposable income.
 Devaluation. A fall in the value of the exchange rate (e.g. Pound Sterling)
makes exports cheaper and increases the quantity of exports (X).  A
depreciation also makes imports more expensive, reducing quantity of
imports and making domestic goods relatively more attractive.
 Confidence. Increased consumer confidence encourages households to
spend by either running down savings or taking out more personal credit. It
enables higher spending (C)., which encourages spending (C).
 Lower tax. Lower income tax will increase the disposable income of
consumers and increases consumer spending (C).
 Rising house prices. A rise in the price of houses creates a positive
wealth effect. Homeowners who see a rise in the value of their houses will
be more willing to spend (remortgaging house if necessary)
 Financial stability. If there is financial stability and banks are willing to
lend, then firms will be more willing to invest and investment will increase
aggregate demand.
2. Long-term economic growth

This requires an increase in the long-run aggregate supply (productive capacity)

as well as AD.

Diagram showing long-run economic growth

LRAS or potential growth can increase for the following reasons:

 1. Increased capital. e.g. investment in new factories or investment in
infrastructure, such as roads and telephones.
2. Increase in working population, e.g. through immigration, higher birth
rate.
3. Increase in labour productivity, through better education and training or
improved technology.

more on labour productivity

4. Discovering new raw materials. For example, finding oil reserves will
increase national output
5. Technological improvements to improve the productivity of capital and
labour e.g. Microcomputers and the internet have both contributed to
increased economic growth. In the future, economic growth may come
from new technology such as Artificial intelligence (AI) which enables
robots to take the place of human workers.
Other factors affecting economic growth

 Economic and political stability. Stability is important for reassuring firms it

is a good idea to invest in increasing capacity. If we see a rise in
uncertainty, confidence tends to fall and this can cause firms to delay
investment.
 Low inflation. Low inflation is a good climate for encouraging business
investment. High inflation increases volatility.
Periods of economic growth in UK

1980s boom

In the 1980s, the UK achieved rapid rates of economic growth, this was caused
by

 Cuts in income tax, increasing disposable income, leading to higher

spending and thereby stimulating business investment
 Boom in house prices, which caused a positive wealth effect, equity
withdrawal and higher consumer spending.
 Rise in confidence, especially amongst south
 Low real interest rates, which made mortgages cheaper.
 See: UK economy in the 1980s
Period of great moderation 1992-2007
The longest period of economic expansion on record was from 1992 – 2007. This
period of economic growth was caused by:

 Low global inflation, which created a period of economic stability.

 A rise in house prices, which helped increase consumer spending.
 Growth in productivity, helped by supply-side reforms.
 Inward investment helped create new jobs and better labour relations.
 See: Great moderation

The great recession of 2008/09 caused by

 Credit crunch and fall in bank lending

 Rise in price of oil – reducing disposable income
 Fall in confidence
 Fall in house prices leading to the negative wealth effect.
 Global recession causing fall in export spending.
Related

Costs of economic growth

28 May 2017 by Tejvan Pettinger
Economic growth means an increase in real GDP – an increase real incomes.
This is usually considered beneficial, but there are also potential costs of
economic growth such as:
The costs of economic growth will depend on the type of growth that we see.

Potential costs of economic growth include

1. Inflation. If Aggregate Demand (AD) increases faster than Aggregate Supply

(AS), then economic growth will lead to higher inflation as firms put up prices.
Economic growth tends to cause inflation when the growth rate is above the long
run trend rate of growth. It is when demand increases too quickly that we get a
positive output gap and firms push up prices.

Gr
aph showing economic growth caused by rising AD leads to inflation.
2. Boom and bust economic cycles. If economic growth is unsustainable then
high inflationary growth may be followed by a recession. This occurred in the UK
in the late 1980s and early 1990s.

In the 1980s there was an economic boom with growth of over 4% a year.
However, this rate of economic growth caused inflation to rise to over 9%. To
reduce this inflation, the government increased interest rates, and this rise in
rates caused the economy to slow down and then enter into a recession.
  However, if economic growth is at a sustainable rate, this will not occur.
For example, between 1993 and 2007, both economic growth and inflation
were at a sustainable rate.

In
this diagram we have AD increasing at the same rate as LRAS. In this case, we
get economic growth without inflation.
3. Current account deficit
Increased economic growth tends to cause an increase in spending on imports,
therefore, causing a deterioration on the current account.

This shows that in the 1980s UK economic boom, there was an increasing deficit
in the balance of goods and services. In the late 1980s, there was high growth in
consumer spending leading to a rise in import spending. In the recession of
1991, there was an improvement in the current account. The UK is susceptible to
a current account deficit during high growth because the UK has a high marginal
propensity to import.

4. Environmental costs
Increased economic growth will lead to increased output and consumption. This
causes an increase in pollution. Increased pollution from economic growth will
cause health problems such as asthma and therefore will reduce the quality of
life. Economic growth also means greater use of raw materials and can speed up
depletion of non-renewable resources. Economic growth can also lead to
problems of congestion as more people can afford to buy a car, but it is hard to
increase the supply of roads to meet demand.
5. Inequality
Higher rates of economic growth have often resulted in increased inequality
because growth can benefit a small section of society more than others. For
example, those with assets and wealth will see a proportionally bigger rise in the
market value of rents and their wealth. Those unskilled without wealth may
benefit much less from growth.
However, it depends upon things such as tax rates and the nature of economic
growth. Economic growth can also be a force for reducing absolute and relative
poverty.

6. Diseases/problems of affluence
With rising living standards it can cause unintended consequences. For example,
with rising incomes, there are more goods to steal. Also, high growth can make
people more materialistic – which encourages crime.  Crime rates have risen
since the 1930s. Also, higher incomes enable people to afford more food – this is
a factor behind rise in obesity and health related problems.

Evaluation
It depends on the nature of economic growth. If growth is balanced and
sustainable, then it can occur without inflation. Also, the environmental costs of
economic growth can be minimised through the better use of technology.

Problems facing an economy

recovering from recession
Outline some of the problems the economy might face in recovering from a
period of recession.
To recover from a recession there needs to be either a rise in AD or a
readjustment in prices and wages.

An increase in aggregate demand will increase GDP and help the economy
recover from recession.

 
 1. Low Consumer confidence
In a recession there will be rising unemployment and therefore a fall in consumer
confidence. This will cause a rise in the savings ratio. In other words people will
spend less of their disposable income and save more leading to a bigger fall in
AD. If confidence remains very low for a long time then it will be difficult for the
governmnent to increase AD. For example if the government cut income taxes
this would increase disposable income but if confidence was low people would
not be willing to spend any extra and the economy would remain in a recession.

2. Ineffectiveness of Monetary Policy

In a recession the Bank of England could cut interest rates to stimulate demand.
Lower interest rates reduce the cost of borrowing and therefore people should be
more willing to spend and invest. However Monetary policy could be ineffective.
Firstly firms may be reluctant to invest, even though it is cheap to borrow,
because they cannot see any increase in demand. If a country is a member of
the Euro may make it more difficult to increase AD in a recession. This is
because interest rates will be set by the ECB and the UK would lose control over
interest rates. Interest rates may be too high if the UK is in a recession and other
countries in the Euro zone are growing too fast.

A problem in the 2008/09 recession was that interest rates were cut to 0.5% but
banks were not keen to lend, therefore the interest rate cut had little impact. In
a liquidity trap, monetary policy becomes ineffective.
3. Effectiveness of Fiscal Policy
Keynesians argue that expansionary fiscal policy can be used to increase AD
and get the economy out of a recession. However there may be many problems
of using fiscal policy to increase AD.


 Firstly there will be time lags. It takes time for the govt to change its
spending plans and once implemented it will take time for this spending
plan to actually increase AD
 Also increasing AD may cause crowding out. This means that if the govt
increases its spending then it will lead to a corresponding fall in private
sector spending. This is because the government borrows off the
private sector to finance its spending. However Keynesians reject this
argument saying that the govt will only be using previously unemployed
resources therefore there will be no crowding out.

 Reluctance to borrow. Even if markets are willing to lend the
government money, there may not be the political wilingness to
increase borrowing. Borrowing automatically rises in a recession.
 4. Deflation
If there is deflation this makes it difficult to increase demand. This is because
people will not spend if they feel that prices will be cheaper in the future. Also
Monetary policy will become ineffective because interest rates cannot fall below
0% therefore with deflation real interest rates may remain high. In the 1920s and
30s, the UK experienced deflation – falling prices discourage people from
spending and increased the real value of debt. In recent years Japan
experienced deflation during the 1990s and 2000s and this made it very difficult
to increase AD and economic growth.
5. Hysteresis
This states that what has happened in the past will affect the future. For example
if unemployment is high then it is likely to continue being high. If people are
unemployed for a long time they become de-motivated and less employable
because they are now less skilled (less on the job training). Also, if productive
capacity is not used for a long time then it firms will shut factories down
completely, causing a fall in Aggregate Supply. Therefore in a prolonged
recession there will be not just a fall in AD but also a fall in AS causing a
permanent fall in the potential output of an economy. This occurred during the
Great Depression of the 1930s.

6. Supply side shocks

If there was a fall in AS as well as AD this would make the recession more
severe. For example if there was a rapid rise in the oil price like in the 1970s then
AS would shift to the left causing lower growth and higher inflation.

Wage adjustment
Classical economists argue that a recession will only be temporary because
labour and product markets are flexible. However Keynesians argue that wage
and price rigidity can keep the economy below full capacity for a long time.

For example to regain equilibrium it may be necessary to reduce price to P3 and

therefore reduce nominal wages by an equivalent amount. However this may be
difficult because trades unions will resist cuts in nominal wages, also firms would
be willing to cut wages because it may lead to lower productivity amongst
workers.

Problems of Recessions
Readers Question: Identify and explain economic variables that may be affected
negatively by the economic slowdown.
Some of the problems of a recession include

 Falling Output. Less will be produced leading to lower real GDP and
lower average incomes. Wages tend to rise much more slowly or not at all.
 Unemployment. The biggest problem of a recession is a rise in cyclical
unemployment. Because firms produce less, they demand fewer workers
leading to a rise in unemployment.
 Higher Government Borrowing. In a recession, government finances
tend to deteriorate. People pay fewer taxes because of higher
unemployment and they need to spend more on unemployment benefits.
This deterioration in government finances can cause markets to be worried
about levels of government borrowing leading to higher interest rate costs.
This rise in bond yields may put pressure on governments to reduce
budget deficits through spending cuts and tax rises. This can make the
recession worse and more difficult to get out of. This was particularly a
problem for many Eurozone economies in the aftermath of 2009 recession.
See: Euro fiscal crisis
 Devaluation of the exchange rate.  Currencies tend to devalue in a
recession because, in a recession, people expect lower interest rates and
so there is less demand for the currency. However, if there is a global
recession and all countries are affected this may not occur.
 Hysteresis. This is the argument that a rise in temporary (cyclical)
unemployment can translate into higher structural (long-term)
unemployment. If someone has been unemployed for a year during a
recession, they may become less employable (e.g. lose on the job training,
e.t.c) See – hysteresis
 Falling asset prices. In a recession, there is less demand for buying fixed
assets such as housing. Falling house prices can aggravate the fall in
consumer spending and also increase bank losses. This fall in asset prices
is particularly a feature of a balance sheet recession (e.g. 2009-10)
recession. See – Balance sheet recession.
 Falling share prices. Lower profits lead to lower levels of share prices.
 Social problems related to rising unemployment, e.g. higher rates of
social exclusion.
 Increased inequality. A recession tends to aggravate income inequality
and relative poverty. In particular, unemployment (relying on
unemployment benefits) is one of the largest causes of relative poverty.
 Rise in Protectionism. In response to a global downturn, countries are
often encouraged to respond with protectionist measures (e.g. raising
import duties). This leads to retaliation and a general decline in trade which
has adverse effects.
Evaluation – can recessions be beneficial?

 Some economists may say an economic downturn is necessary to solve

inflation. For example, recessions of 1980 and UK recession of 1991/92.
 Recessions can force firms to be more efficient and the ‘creative
destruction’ of a recession can allow new firms to emerge.
However, these factors don’t outweigh the high personal and social costs of
recession.

Examples of recession US 2008/09

Economic growth

Recession 2008-2009. Fall in real GDP

Unemployment

Unemployment started to rise just as the economy went into recession.

Government borrowing
US Federal Deficit. A sharp rise in government borrowing in 2009. This was
partly due to automatic stabilisers but also expansionary fiscal policy (tax cuts
and higher spending)

US house prices

House prices fell just before the recession started in 2006; falling house prices
were a factor in causing the recession. But, as the recession started, house
prices fell further.

Great Depression 1929-32

The Great Depression was a much more serious recession, with output falling
over 26% in three years.
It led to a much higher rate of unemployment – with the rate rising from 0% to
25% in two years time.

What happens in a recession?

A recession is a period of negative economic growth. In a recession, we see
falling real GDP, falling average incomes and rising unemployment.
This graph shows US economic growth 2001-2016. The period 2008-09 shows
the deep recession, where real GDP fell sharply.
Other things we are likely to see in a recession

1. Unemployment

The rise in unemployment 2008-09 mirrors the fall in real GDP.

In a recession, firms will be producing less and therefore will need fewer workers.
Also, in a recession, some firms will go out of business, causing workers to lose
their jobs. For example, after the credit crunch of 2008/09, many working in the
finance industry lost their jobs in banking. Then when demand for cars fell, car
firms started to lay off workers too.

2. Increase in saving ratio

UK saving rate rose sharply in the recession of 2008/09

 In a recession, people tend to save money because there is a fall in

confidence. If people expect to be made unemployed (or fear
unemployment), then you don’t want to spend and borrow, saving
becomes more attractive.
 Keynes noted that in the great depression, there was a paradox of thrift –
because people saved more and reduced consumption, this makes the
recession worse because it causes a further fall in consumption.
Individually they are doing the right thing, but because many people are
saving more – they are further reducing consumer spending and making
the recession worse.
3. Lower inflation rate

US inflation was high in 2008 due to rising oil prices. But, the recession of 2009
caused a sharp drop in the inflation rate – for a period, there was falling prices
(deflation)

With a fall in aggregate demand and lower economic growth, this puts downward
pressure on prices. In a recession, you are more likely to see shops selling at a
discount to sell unsold goods. Therefore, we tend to get a lower inflation rate. In
the Great Depression of the 1930s – we saw deflation – when prices fell.

See also: Pricing strategies in recession

4. Fall in interest rates
 In recessions, interest rates tend to fall. This is because inflation is lower
and Central Banks wish to try and stimulate the economy. Lower interest
rates, in theory, should help the economy from recession. Lower interest
rates reduce the cost of borrowing and should encourage investment and
consumer spending.
5. Government borrowing increases

US debt as a % of GDP rose after the start of the recession in 2008.

In a recession, we will see higher government borrowing. This is for two reasons:

 Automatic stabilisers. With rising unemployment, the government will need

to spend more on unemployment benefits. However, because fewer
 people are working, they will receive less income tax. Also, firms
profitability falls, so corporation tax receipts fall.
 Secondly, the government may also try to use expansionary fiscal policy.
This involves cutting tax rates and increasing government spending. The
idea is to make use of surplus private sector savings and get unemployed
resources back into use. For example, Obama’s stimulus package of 2009.
See Obama economics.
6. Stock market falls
 Stock Markets may fall because firms make less profit. There is also the
danger firms may go out of business.
 If stock markets anticipated the recession, it might already be built into
share prices. Share prices do not necessarily fall in a recession.
 But, if the recession is unexpected then profit forecasts will be
downgraded, and share prices generally fall.
7. Fall in house prices

In this case, US house prices fell before the recession. House price falls were a
cause of the recession. They didn’t recover until the end of 2012.

In a recession, with rising unemployment, many may not be able to afford their
mortgages, and so we can see home repossessions. This will lead to an increase
in the supply of housing and less demand. In the 2008 recession, US house
prices fell sharply because of the previous housing boom. In fact, the bursting of
the housing/mortgage bubble in 2005/06 was a factor behind that recession.

8. Investment. Investment will fall as firms cut back on risk-taking and

uncertainty. It may also be harder to borrow if banks are short of liquidity (e.g.
credit crunch of 2008). Investment is usually more volatile than economic growth
due to factors such as the accelerator theory.
AD/AS Model
Simple AD/AS framework showing the effect of a fall in AD leading to lower real
GDP and lower price level.

Other possible effects

9. Hysteresis effect. This states that the temporary rise in unemployment could

translate into permanently higher structural unemployment. For example,
manufacturing workers who lost a job in the 1981 recession took time to find new
jobs in the service sector. See hysteresis effect.
10. Depreciation in the exchange rate. A recession which affects one country
more than others could lead to depreciation. This is because there is less
demand for the currency if interest rates fall (worse return)
In 2008/09, the UK saw a sharp depreciation in the value of the Pound because
the credit crunch particularly affected the UK economy which was reliant on the
finance sector.

Pound Sterling fell in 2008/09 recession

However, in the 1981 recession, the Pound was strong. In fact the strength of
Pound was a factor in causing recession.

11. Creative destruction and new firms. Some economists are more positive
about recessions suggesting that a recession can force inefficient firms out of
business and enable more innovative and efficient firms to come to the fore.
 However, good firms can go out of business in a recession due to
temporary factors rather than long-term lack of competitiveness.
12. Current account on balance of payments. If a country experiences a sharp
fall in domestic consumption – it could see an improvement in the current
account deficit. This is because import spending will fall.

In the 1981 and 1991 recession, the UK saw an improvement in the current
account. But, the improvement in current account in 2009 was relatively short-
lived.

Evaluation
 It depends on the causes of the recession. For example in mid-1970s
recession was caused by high oil prices. Therefore, inflation was higher
than usual in a recession.
 In the 1981 recession, the high value of the Pound hit the manufacturing
(export) sector hard. In the 1991/92 recession, homeowners bore a higher
burden because the recession was caused by very high-interest rates,
 which made mortgages expensive. In the 2008 recession, it was the
finance and banking sector which experienced the biggest falls.
 It depends on whether the recession is global or specific to a country. In
1981 and 1991, the UK recession was deeper than elsewhere in the world
 It depends on the response of governments/Central Bank. For example, in
1931, UK tried to balance the budget – causing further falls in aggregate
demand.

Causes of recessions
4 March 2019 by Tejvan Pettinger

Recessions (a fall in real GDP) are primarily caused by a fall in aggregate

demand (AD). A demand-side shock could occur due to several factors, such as
 A financial crisis. If banks have a shortage of liquidity, they reduce
lending and this reduces investment.
 A rise in interest rates – increases the cost of borrowing and reduces
demand.
 Fall in asset prices – negative wealth effect leads to less spending.
 Fall in real wages – e.g. inflation outstripping nominal wage increases.
 Fall in consumer/business confidence also exacerbated by the negative
multiplier effect.
 Appreciation in exchange rate – exports less competitive.
 Fiscal austerity – when government cuts spending.
 Trade war – Global economic downturn.
Recessions can also be caused by

 Supply-side shock, e.g. rise in oil prices cause inflation and lower
spending power. (e.g. in 1970s)
 Black swan event – this is an unexpected event that is very hard to
predict. For example, Covid-19 flu pandemic which disrupts travel, supply
chains and normal business activity. A pandemic affects both supply and
demand.
Causes of recession
1. Demand Side Shock

Factors that can cause a fall in aggregate demand include:

 Higher interest rates which reduce borrowing and investment. For

example, in the early 1990s, the UK increased interest rates to 15%, this
caused mortgage payments to rise and consumers had to cut back
spending.
 Falling real wages. For example, firms cutting wages (or freezing wages)
but inflation erodes the real value of wages.
 Falling consumer confidence, (e.g. negative series of events causes
consumers to delay spending). Lower confidence also reduces business
investment. Confidence can cause a knock-on effect, with low confidence
affecting other consumers and business. Fall in confidence was a big
factor in 2008/09 when bank crisis affected consumer behaviour.
 Credit crunch which causes a decline in bank lending and therefore lower
investment.
 A period of deflation. Falling prices often encourage people to delay
spending. Also, deflation increases the real value of debt causing debtors
to be worse off and less disposable income.
 Appreciation in the exchange rate which makes exports expensive and
reduces demand for exports. In 1981, the UK had a sharp appreciation in
 the Pound Sterling (partly due to North Sea Oil) – this caused a sharp fall
in exports.
2. Supply Side Shock

Higher oil prices would increase the cost of production and causes the short-run
aggregate supply curve to shift to the left.

This supply-side shock causes lower real GDP and higher inflation. This is
difficult to solve with monetary policy – because we have both inflation and lower
output to try and solve. (Changing interest rates can’t do both at once.)

 Confidence. A fall in confidence can precipitate a recession. See: Can we

talk ourselves into recession?
What could cause the next global recession in 2020?

1. Covid-19 – flu pandemic which causes disruption to trade, manufacturing,

travel and business confidence. (See: economic effects of pandemic)
2. Trade war between the US and China leading to lower export but perhaps,
more importantly, discouraging business investment due to uncertainty.
3. No-deal Brexit in the UK could lead to major disruption and fall in trading
between the UK and EU would push the EU into recession
 4. Fall in house prices. Asset prices have recovered since last crash in 2008,
and some analysts believe they are overvalued. Falling house prices have
a major effect on consumer wealth and spending.
5. Austerity in Germany has caused squeeze in aggregate demand.
6. General weakness in global economy – weak productivity growth –
see: Tortoise economy
7. Limited room for monetary/fiscal policy. Interest rates already quite low –
little room for a monetary boost. In the US, large deficit after tax cut may
limit the scope for expansionary fiscal policy
Examples of recessions in the US

1. Great Depression 1929-32

US economy experienced an unprecedented downturn 1929-32

 Stock market crash in 1929 caused financial turmoil and decline in

confidence. Many investors had bought shares on the margin (basically
borrowing to buy). This caused people to lose significant sums.
 In US, bank failures led to a fall in the money supply and deflationary
pressures. Bank failures also caused lost confidence and discouraged
investment
 Negative multiplier effect – initial fall in spending caused a knock-on effect
throughout the economy. There were no automatic stabilisers. People
were made unemployed and so started spending less themselves.
 Fall in trade due to the global nature of downturn.
 Up until 1932, deflationary fiscal policy (higher taxes, lower spending)
worsened the situation. The belief that budgets must be balanced caused
governments to put up taxes and reduce spending – when the opposite
needed to occur.
 More detail at causes of the great depression
Causes of UK recessions

1981 Recession

1981 recession was caused by:

1. High value of the pound which made exports more expensive and

reduced demand for exports. This recession particularly impacted on
British manufacturing. The Pound soared due to the discovery of North
Sea Oil but also the high-interest rates.
 2. High-interest rates. In 1979, inflation in the UK was over 15%. The new
Conservative government was committed to reducing high inflation they
inherited. They pursued a tight monetary policy (higher interest rates) and
tight fiscal policy (higher taxes, lower government spending. This reduced
inflation but at the cost of falling spending, investment and output.
3. Tight Fiscal Policy. To control inflation, the government were committed
to reducing the levels of Government borrowing. This was influenced by
Monetarist beliefs that controlling excess government borrowing was
essential to the economy. Therefore the government increased taxes
which reduced the disposable income of consumers and therefore reduced
consumer spending.
more on 1981 recession
1991 Recession

1. BOOM and BUST. In the 1980s economic growth was too fast and
unsustainable therefore inflation increased to over 10% (see: Lawson
boom). To reduce this inflation the government increased interest rates
which lowered spending.
2. Joining the exchange rate mechanism. The government became
committed to maintaining a high value of the Pound. This required high-
interest rates of up to 15%, which caused a big fall in aggregate demand.
Also, because the pound was overvalued, exports were expensive causing
less demand for UK exports.
3. High-interest rates increased the cost of mortgage interest payments.
Many were forced to sell. This caused a fall in house prices. Falling house
prices caused a decline in consumer wealth and lower confidence. This
also caused lower spending.
more on: 1991 recession
Causes of the recession of 2008/09

 Credit crunch – shortage of finance (Credit Crunch explained)

 Falling house prices – related to shortage of mortgages and credit crunch
 Cost-push inflation from rising oil prices squeezing incomes and reducing
disposable income
 Collapse in confidence of finance sector causing lower confidence
amongst the ‘real economy.’
 Fall in real wages due to inflation, but squeezed nominal wages.
Essay on causes of recession
A recession occurs when there is a fall in economic growth for two consecutive
quarters. However, if growth is very low there will be increased spare capacity
and increased unemployment; people will feel there is a recession. This is
sometimes known as a growth recession. see also: Definition of Recessions
If there is a fall in aggregate demand (AD) then according to Keynesian analysis
there will be a fall in Real GDP. The effect on Real GDP depends upon the slope
of the AS curve if the economy is close to full capacity lower AD would only
cause a small fall in Real GDP.

AD is composed of C+I+G+X-M, therefore a fall in any of these components

could cause a recession. For example, if the MPC increased interest rates
sharply this would cause the cost of borrowing to increase and make saving
more attractive. This would have the effect of reducing consumer spending. AD
could also fall due to deflationary fiscal policy, for example, higher taxes and
lower government spending would also cause a fall in AD.

If there was a fall in AD the multiplier effect might magnify the initial fall in AD.
For example, if there was a fall in output, workers would be made unemployed.
These workers would then spend less causing a secondary fall in AD. This would
make the fall in Real GDP greater.

A key feature in determining the rate of economic growth is the level of consumer
and business confidence. If confidence was high then higher interest rates may
not reduce demand. However if confidence is low and people fear they may be
made unemployed, then they will start spending less, causing AD to fall (or
increase at a slower rate). Therefore this shows that expectations are very
important and it is possible for “people to talk themselves into a recession”

An important feature of the UK economy is international trade. Therefore the UK

would be affected by a global recession. For example, a recession in the EU
would cause a fall in demand for UK exports reducing our AD (EU accounts for
60% of our trade, therefore, is important). Also, a recession in other countries
would affect economic confidence if people see the US in a recession they are
worried and will spend less. However, a global recession may not cause a
recession in the UK if domestic demand remains high.

Classical economists believe that any fall in Real GDP will be temporary and will
end when labour markets adjust to the new price level. Classical economists
argue that if there is a fall in AD then, in the short term, there will be a fall in real
GDP. However with a lower price level wages will fall therefore the SRAS will
shift to the right and the economy will return to the original level at Yf and the
recession will be over.

However in the great depression of 1930s, Keynes was very critical of this
classical view he said that the long period of negative growth showed that
markets do not automatically clear he argued that this was for various reasons.

1. Wages are sticky downwards. Firms should cut wages to reflect lower
prices but in reality, workers are very resistant to cuts in nominal wages
2. If wages were cut in response to unemployment, workers would have less
spending power, therefore AD would continue to fall.
3. In a recession, people have low confidence and therefore spend less.
Keynes said this was the “Paradox of Thrift”

Government policies to reduce

collusion
Collusion involves firms coming to an agreement to artificially raise prices and
increase profitability at the expense of consumers. Collusion can lead to
significant welfare loss and governments have sought to prevent it through a
variety of policies, including:

 Fines for firms found guilty of collusion

 Fines and jail sentences for company executives who are personally liable.
 Detecting collusion through screening markets for suspicious pricing
activity and high profitability.
 Offering immunity to the first firm who comes clean and gives the
government information about collusion. This is known as ‘leniency
programmes’
 Regulation of mergers. Preventing mergers which lead to high
concentration ratios, where collusion is more likely.

Preventing collusion

1. Detection through leniency programmes. To prevent collusion,

governments first have to detect it. In a paper “Cartels as Rational Business
Strategy: Crime Pays”(2011)  by Connor and Lande, they argue the chance of a
cartel being detected is as low as one in five. This is because if firms are careful,
they can collude without leaving any evidence.
In the US, the Department of Justice has investigative powers and in the EU it is
the EU Commission. Mostly the commissions rely on tip-offs. One way to detect
collusion is to give firms a strong incentive to give information to the government.
The US brought in a law that the first firm who gives information on a cartel are
immune from criminal charges and penalties. The 2nd and 3rd firm who co-
operate do not get immunity but significantly lower sentences. The strength of
this policy is that it creates uncertainty amongst colluders because – if in doubt –
it makes sense to confess early and avoid charges.

 However, a leniency programme on its own is not sufficient to prevent

collusion. If firms are patient and think the probability of getting fined is less
that profitability of collusion. W. Emons (2018) argues that leniency may or
may not prevent collusion when firms can choose the degree of
collusion “The effectiveness of leniency programs when firms choose the
degree of collusion.“
2. Higher fines. The European cement industry was investigated for collusion.
The Economist notes a report from the investigation that an executive said “… it’s
hard to stop fixing prices when it’s still so worthwhile.” In “Cartels as Rational
Business Strategy: Crime Pays” (2011) the authors claim that sanctions for
collusion only accounts for a small percentage of the extra profits gained from
collusion. They estimate the penalty for collusion is only 9% to 21% as the
rewards from collusion. Therefore, there is a clear financial incentive for firms to
collude. A firm weighs up the
Net gain from collusion = Extra profits from collusion – (Penalty * chance of being
caught).

In this case, higher fines would make collusion less rational. Combined with
leniency programmes, it increases the incentive to be a whistleblower and avoid
the heavy fines. The higher fines would also compensate consumers for loss of
economic welfare from the period of collusion.

However, some firms have argued that fines from collusion are excessive and
could in some cases bankrupt firms causing a decline in competition.

An example of major fines was in 2012 – major tv producers were given record
fines for collusion in the provision of cathode-ray tubes causing the price of tv
sets to rise. The European Commission (EC) passed a total of fines worth €1.4bn
(£1.1bn) to several firms including Philips, Samsung, SDI, LG, Panasonic and
Toshiba. Phillips said it would challenge what is considered a disproportionate
and unjustified penalty. (Link)
In addition to government fines, the increased threat of civil litigation creates
another financial cost of collusion.

3. Hold executives personally responsible. The US leads the way for holding
executives personally responsible for engaging in illegal collusion. The personal
threat of jail and a criminal record is much greater than the personal rewards of
increasing firms profits. Given even a small risk of getting sent to jail, it is a large
disincentive to take the risk of collusion. In the UK an executive can face up to
five years in jail for cartel activity (though it is rarely imposed) After the LIBOR
price-fixing cartel was exposed, major banks were fined large sums (Barclays
fined £200m by CFTC,  $160 million by the US D of J and £59.5 million by the
FSA.  Four former Barclays bank employees were sentenced to a total of 17
years. (SFO)
4. Screening of suspicious pricing behaviour. Modern technology enables
governments to monitor suspicious pricing patterns which may indicate collusion
and further investigation. This may need to be combined with information on
profitability. For example, it can become hard to distinguish between normal price
changes (e.g. airlines adjusting prices depending on demand) to formal collusion.
Suspicious pricing behaviour was significant in the Libor scandal when it was
shown banks were falsely inflating their rates to profit from trades.
This financial screening has become more viable with improvements in
technology and AI logarithms. However, it works best in industries with
substantial data. It also has limitations – firms could manipulate data. More
worryingly it can easily lead to false positives. The US Department of Justice
tried “screeing: but had to ditch it after too many false positives were created.

5. Increasing the enforcement budget. In 2012, the Department of Justice

gained in revenue from fines 16 times more than the cost of running it. A bigger
budget would enable more scrutiny and discourage collusion.
6. Regulation of mergers. Collusion is more likely in certain markets with similar
products, easy to check prices, barriers to entry and often low-visible
components (rather than retail end products) In these industries vulnerable to
collusion, mergers must be closely monitored and blocking any merger which
leads to significant fall in competition. In extreme cases, governments could
consider splitting up powerful monopolies to try and increase competition.

Collusion – meaning and examples

Collusion occurs when rival firms agree to work together – e.g. setting higher
prices in order to make greater profits. Collusion is a way for firms to make higher
profits at the expense of consumers and reduces the competitiveness of the
market.
In the above example, a competitive industry will have price P1 and Q
competitive. If firms collude, they can restrict output to Q2 and increase the price
to P2.

Collusion usually involves some form of agreement to seek higher prices. This
may involve:

 Agreeing to increase prices faced by consumers.

 Deals between suppliers and retailers. For example, vertical price-fixing
e.g. retail price maintenance. (For example, Fixed Book Price (FBP) set
the price a book is sold to the public.
 Monopsony pricing – where retailers collude to reduce the amount paid to
suppliers. For example, a retailer with great buying power (Walmart,
Amazon) can offer very small profit margins to suppliers as they have little
alternative.
 Collusion between existing firms in an industry to exclude new firms from
deals to prevent the market from becoming more competitive.
 Sticking to output quotas and higher prices.
  Collusive tendering. For example, ‘cover prices’ for competitive tendering
in bidding for public construction contracts. This is when a rival firm agrees
to set artificially high price to allow the firm of choice to win with a relatively
high contract offer.
Types of collusion
 Formal collusion – when firms make formal agreement to stick to high
prices. This can involve the creation of a cartel. The most famous cartel
is OPEC – an organisation concerned with setting prices for oil.
 Tacit collusion – where firms make informal agreements or collude
without actually speaking to their rivals. This may be to avoid detection by
government regulators.
 Price leadership. It is possible firms may try to unofficially collude by
following the prices set by a  market leader. This enables them to keep
prices high, without ever meeting with rival firms. This kind of collusion is
hard to prove whether it is unfair competition or just the natural operation
of markets.
Problems of collusion

Collusion is seen as bad for consumers and economic welfare, and therefore
collusion is mostly regulated by governments. Collusion can lead to:

 High prices for consumers. This leads to a decline in consumer surplus

and allocative inefficiency (Price pushed up above marginal cost)
 New firms can be discouraged from entering the market by types of
collusion which act as a barrier to entry.
 Easy profits from collusion can make firms lazy and avoid innovation and
efforts to increase productivity.
 Industry gets the disadvantages of monopoly (higher price) but none of the
advantages (e.g. economies of scale)
Justification for collusion

 In times of unprofitable business conditions, collusion may be a way to try

and save the industry and prevent firms from going out of business, which
wouldn’t be in the long-term consumer interest. Dairy suppliers tried to use
this justification in 2002/03 after problems from foot and mouth disease led
to a decline in farm incomes.
 Research and development. Profits from collusion could, in theory, be
used to invest in research and development.
Examples of collusion
Milk price by supermarkets 2002-03
After a period of low milk, butter and cheese prices, supermarkets such as Asda
and Sainsbury’s colluded with Dairy suppliers, Dairy Crest and Wiseman Dairies
to increase the price of milk, cheese and other dairy products in supermarkets.
After an OFT investigation, supermarkets and suppliers were fined a total of
£116m.

The OFT found prices set by supermarkets went up by three pence per pint of
milk, but the income received by farmers did not go up. Milk collusion at BBC
Bank loans collusion – RBS and Barclays 2008-2010

In 2010 the OFT found RBS and Barclays guilty of collusion in sharing price
arrangements for loans to professionals, such as lawyers and accountants.
Sharing price information is a way to avoid price competition and keep prices
high. RBS was fined £28.59m. (Independent)
Recruitment agencies forum cartel 2004-06
Between 2004 and 2006 six recruitment companies formed a cartel called the
“Construction Recruitment Forum” which met to fix prices for supplying labour to
intermediaries and construction companies. They also excluded a new firm Parc
from any dealings. Hays was fined £30.4 million for a ‘Serious breach of
competition law.’ BBC link
Collusion in the construction industry – collusion on tender price
In bidding for public sector construction work, construction firms would collude in
setting artificially high prices. Firms would decide which contracts they wanted,
and rivals would bid purposefully high price. This is a practice known as “Cover
pricing”. Successful companies would often reward rivals with a secret payment
for avoiding competition.

During the investigation, the OFT found 199 offences where the 103 companies
artificially inflated £200m worth of work. Companies were fined a total of £129.5m
by the OFT. Guardian link.
Price fixing in air travel – British Airways and Virgin 2004-06
In 2007, British Airways was fined £270m for illegal price-fixing arrangements
with Virgin on long haul flights. The two companies met to agree and collude on
the extra price of fuel surcharges in response to rising oil prices. Between 2004
and 2006, surcharges on air tickets rose from £5 to £60 per ticket. The £270m
fine compares to an annual profit of £611m for BA. BBC link on collusion.
Regulation for collusion

In the UK, the Competition Act of 1998, states the OFT has the power to impose
penalties on companies of up to 10 per cent of their worldwide turnover for
breaches of competition law.
Firms which act as whistleblowers can gain immunity from penalties. Therefore, if
two firms are colluding there is an incentive to be the first to blow the whistle and
give information to the OFT.

Game theory and collusion

Collusion enables both firms to make £8m – compared to the competitive

equilibrium of £3m.

 If a market is competitive, firms will end up with low prices and low profits.
 Collusion is a way for firms to benefit from higher prices and high profits.
 However, collusion is an unstable equilibrium. When prices are high, a firm
in a cartel has an incentive to ‘cheat’ – exceed its quotas and try to benefit
from both high prices and higher output. But, if a firm exceeds its quotes,
the collusion is likely to break down as other firms follow suit.
 Another factor that makes collusion unstable is the law. If a firm reports the
collusion to the regulator, then the firm is immune from being fined; it is the
other firm which will suffer. Therefore, in collusion, there is a strong
incentive to be first to confess. It is a very risky strategy to continue with
the collusion, hoping the other firm won’t run to the regulator.
 This is why the law is designed as it is – with a strong incentive to be the
one to confess. The downside is that firms who collude for a long-time can
be immune from prosecution and being fined.
Pricing strategies
A look at different pricing strategies a firm may use to try and increase
profitability, market share and gain greater brand loyalty.

Types of pricing strategies

General strategies
1. Profit maximisation. One strategy is to ignore market share and try to work
out the price for profit maximisation. In theory, this occurs at a price where
MR=MC. In practice, it can be difficult to work this out precisely.
2. Sales maximisation. Aiming to maximise sales whilst making normal profit.
This involves selling at a price equal to average cost.
3. Gaining Market Share. Some firms may have a target to increase market
share, this could involve setting prices as low as they can afford, leading to
a price war. A similar concept to sales maximisation.
See: Objectives of firms
Pricing strategies to attract customers / increase profit
 Premium pricing. This occurs when a firm makes a good more expensive
to try and give the impression that it is better quality, e.g. ‘premium
unleaded fuel’, fashion labels.
 Loss Leaders This involves setting a low price on some products to entice
customers into the shop where hopefully they will also buy other goods as
well. However, it is illegal to sell goods below cost, so firms could be
investigated by OFT.
 Price Discrimination. This involves charging a different price to different
groups of consumers to take advantage of different elasticities of demand.
There are different types of price discrimination from first degree to third
degree.
 Reference Pricing. This involves setting an artificially high price to be able
to later offer discounts on previously advertised price.
 Price Matching. The purpose behind price matching is making a promise
to match any price cuts by your competitors. The argument is that this
discourages your competitors from cutting price. This is because they
know there is little point in cutting prices because you will respond straight
away. Very clear price matching stances can thus avoid price wars and
give the impression of being very competitive. For example, Tesco is
offering £10 voucher to customers who can prove their shopping basket
would have been cheaper at other supermarkets.
 Retail price mechanism RPM – when manufacturers set minimum prices
for retailers, e.g. net book agreement.
  Psychological pricing. Setting price at important psychological levels to
trigger purchase, e.g. selling good at £9.99 to make it appear cheaper.
Some firms use reverse psychology and charge exact prices, e.g. clothes
for £40 to indicate quality rather than cheapness.
 Premium decoy pricing. Where a firm sets the price of one good
deliberately high to encourage demand for a lower price. e.g. a car
company may bring out a top of the range sports car, which is very
expensive to make the general brand more attractive.
 Pay what you want. A situation where consumers are left free to decide
how much to pay, e.g. restaurants cafe where there is no cost – only
tipping. When music companies release a new recording and ask for
donations.
 Bundle pricing. When a firm gives special offers, e.g. buy 3 for the price
of 2 – very common for book sales e.t.c.
 Price skimming. When a firm releases a new product, it initially sets a
high price to take advantage of those consumers with inelastic demand.
Over time, the price is reduced to attract those customers with more price
elastic demand.
 Penetration pricing. When a firm sets a low price to help establish market
share and get established. For example, a new printing company may offer
very low price for its printers to get established. Then it gets to make profits
on selling ink and over time increase the price. Or satellite tv company
offering introductory offer for a few months.
 Optional pricing. When a firm tries to receive a higher price by selling
extras. For example, if you buy a DVD, you can get sold insurance or
additional features.
 Dynamic pricing. When prices are regularly updated in response to
shifting market conditions. For example, if an airline receives high demand
for certain flights, it will increase the price to help fill up other departure
times and maximise revenue from the flight.
Pricing strategies to cement market share/market position
 Limit pricing. This occurs when a monopoly set price lower than profit
maximisation to discourage entry. This enables the firm to make
supernormal profit, but the price is still low enough to deter new firms to
enter the market.
 Predatory pricing. Selling price below cost to try and force rival out of
business. Predatory pricing is illegal. Predatory pricing can be made easier
through cross Subsidisation. This occurs when a big multinational may use
profits in one area to subsidise a price war in another. The cross
subsidisation enables a firm to sell a product very competitively (or even at
a loss) to try and force the rival firms out of business.
Pricing strategies to help determine the price
 Average cost pricing. When a firm sets the price equal to average cost plus
a certain profit margin.
 Market-based pricing. When firms set a price depending on supply and
demand. For example, if football clubs, used market-based pricing, clubs
like Manchester United would probably increase the ticket price – because,
at the moment, all tickets are sold out – suggesting price is below the
equilibrium.
 Markup pricing. This involves setting a price equal to marginal cost of
production + x. (where x = the profit margin a firm wants to make on each
sale)
 Profit maximisation. Setting price and quantity so MR=MC

If demand for your products is highly elastic, cutting prices should lead to an
increase in revenue. Increasing prices will lead to a fall in revenue.If demand is
price inelastic, then you can increase your profits by increasing your price.

This is the logic behind price discrimination. Firms charge a higher price to that
market segment where demand is more price inelastic, but a lower price to where
demand is more price elastic.
What will determine the most effective pricing strategy?

The optimal pricing strategy will depend on the type of firm. For example, if you
are considered to having a premium brand – cutting price could be perceived as
disastrous as you lose your brand image, and fail to increase sales. For these
products, it might be better to maintain premium pricing and optional pricing. For
normal goods, with firms looking to increase market share and gain more market
dominance, it is more important to offer competitive prices, through strategies
such as penetration pricing and even loss leaders.

Oligopoly
Definition of oligopoly
An oligopoly is an industry dominated by a few large firms. For example, an
industry with a five-firm concentration ratio of greater than 50% is considered a
monopoly.

Examples of oligopolies

Car industry – economies of scale have cause mergers so big multinationals

dominate the market. The biggest car firms include Toyota, Hyundai, Ford,
General Motors, VW.

 Petrol retail – see below.

 Pharmaceutical industry
  Coffee shop retail – Starbucks, Costa Coffee, Cafe Nero
 Newspapers – In UK market share dominated by tabloids Daily Mail, The
Sun, The Mirror, The Star, Daily Express.
 Book retail – In UK market share is dominated by Waterstones, Amazon
and smaller firms like Blackwells.
The main features of oligopoly

 An industry which is dominated by a few firms.

The UK definition of an oligopoly is a five-firm concentration ratio of more than

50% (this means the five biggest firms have more than 50% of the total market
share) The above industry (UK petrol) is an example of an oligopoly. See
also: Concentration ratios
 Interdependence of firms – companies will be affected by how other
firms set price and output.
 Barriers to entry. In an oligopoly, there must be some barriers to entry to
enable firms to gain a significant market share. These barriers to entry may
include brand loyalty or economies of scale. However, barriers to entry
are less than monopoly.
 Differentiated products. In an oligopoly, firms often compete on non-price
competition. This makes advertising and the quality of the product are
often important.
  Oligopoly is the most common market structure
How firms compete in oligopoly

There are different possible ways that firms in oligopoly will compete and behave
this will depend upon:

 The objectives of the firms; e.g. profit maximisation or sales maximisation?

 The degree of contestability; i.e. barriers to entry.
 Government regulation.
There are different possible outcomes for oligopoly:

1. Stable prices (e.g. through kinked demand curve) – firms concentrate on

non-price competition.
2. Price wars (competitive oligopoly)
3. Collusion- leading to higher prices.
The kinked demand curve model

This model suggests that prices will be fairly stable and there is little incentive for
firms to change prices. Therefore, firms compete using non-price competition
methods.

 This assumes that firms seek to maximise profits.

 If they increase the price, then they will lose a large share of the market
because they become uncompetitive compared to other firms. Therefore
demand is elastic for price increases.
  If firms cut price then they would gain a big increase in market share.
However, it is unlikely that firms will allow this. Therefore other firms follow
suit and cut-price as well. Therefore demand will only increase by a small
amount. Therefore demand is inelastic for a price cut.
 Therefore this suggests that prices will be rigid in oligopoly
The diagram above suggests that a change in marginal cost still leads to the
same price, because of the kinked demand curve.  Profit maximisation occurs
where MR = MC at Q1.

Evaluation of kinked demand curve

 In the real world, prices do change.
 Firms may not seek to maximise profits,  but prefer to increase market
share and so be willing to cut prices, even with inelastic demand.
 Some firms may have very strong brand loyalty and be able to increase the
price without demand being very price elastic.
 The model doesn’t suggest how prices were arrived at in the first place.
Price wars

Firms in oligopoly may still be very competitive on price, especially if they are
seeking to increase market share. In some circumstances, we can see
oligopolies where firms are seeking to cut prices and increase competitiveness.

A feature of many oligopolies is selective price wars. For example, supermarkets

often compete on the price of some goods (bread/special offers) but set high
prices for other goods, such as luxury cake.

Collusion

 Another possibility for firms in oligopoly is for them to collude on price and
set profit maximising levels of output. This maximises profit for the
industry.
In the above example, the industry was initially competitive (Qc and Pc).
However, if firms collude, they can agree to restrict industry supply to Q2, and
increase the price to P2. This enables the industry to become more profitable. At
Qc, firms made normal profit. But, if they can stick to their quotas and keep the
price at P2, they make supernormal profit.

 Collusion is illegal, but tacit collusion may be hard to spot.

 For collusion to be effective, there need to be barriers to entry.
 A cartel is a formal collusive agreement. For example, OPEC is a cartel
seeking to control the price of oil.
See: Collusion
Collusion and game theory

Game theory is looking at the decisions of firms based on the uncertainty of how
other firms will react. It illustrates the concept of interdependence. For example, if
a firm agrees to collude and set low output – it relies on the other firm sticking to
the collusive agreement. If the firm restricts output (sets the High price), and then
the other firm betrays its agreement (setting low price). The firm will be worse off.
This shows different options. If the market is non-collusive, firms make £3m
each. If they collude, they make £8m. But, there is an incentive for firms to
exceed quota and increase output.

Collusion and game theory is more complex if we add in the possibility of firms
being fined by a government regulator.

Collusion is illegal and firms can be fined. Usually, the first firm who confesses to
the regulator is protected from prosecution, so there is always an incentive to be
the first to confess.

Prices and incomes policy

Prices and incomes policy is an attempt by the government to set the rate of
increase in prices and the rate of wage increases in the economy.

The government do not seek to control individual prices but control the general
rate of increase in prices and incomes. Price and incomes policy may involve
‘voluntary’ agreements or statutory limits on wage increases.

Price and incomes policies were adopted in the UK, in different forms, in the
1960s and 1970s, but the stagflation of 1970s left the policies discredited and the
policy has generally been abandoned in the UK. In some western European
economies, the government may still seek to influence wage negotiations. In
Scandanavia, the government has no formal role in wage bargaining but can
exert significant influence in negotiations.
Prices and incomes policies were seen as a solution to excess inflation –
especially in a period of high growth. It was hoped that controlling price and wage
increases would enable economic growth and low unemployment – without
inflation.

Initially, the UK  suggested voluntary limits but in 1966 the government
introduced Prices and Incomes orders which could limit price and wage
increases by law.

Different forms of incomes policies

 Statutory limits on wage increases – the government set wage limits on

unions and firms
 Social contract. The government try to cultivate a social contract with
unions, business and government to agree on wage and prices in the
national interest. It requires a strong degree of co-operation which was
often lacking.
 Wages linked to productivity gains
 Voluntary agreements where unions and firms encouraged to accept
national wage increases

Arguments for Incomes policies

Deal with monopoly power of trade unions. In the 1960s and 70s, trade
unions had significant bargaining power and this gave an ability to demand
higher wage increases. It was argued that unions could push wages above
equilibrium wages and benefit members at the expense of inflation and the
unemployed. Also, high wage increases limited the scope for firms to invest in
capital.
By the mid-1970s, several economists noted that workers were taking the biggest
share of national income ever. For example, between 1950 and 1970, the share
of profits in company output had fallen from 25% to 12%, whilst the share of
wages had risen from 75% to 87%. This suggested unions were successful in
gaining a higher share of national output

Glyn, Andrew, and Sutcliffe, Bob, British capitalism, workers and the profits
squeeze
Wages increases for firms with monopsony power. On the other hand,
workers who do not have collective bargaining strength may find it difficult to get
any wage increase – even in a time of inflation. An incomes policy could help this
sector of low-paid workers.
Prevent wage-price spiral. If wages increased faster than the previous year,
firms will feel the need to pass on price increases to consumers, causing higher
inflation. Also, with higher wages, workers have increased nominal income and
so demand rises, causing further inflationary pressure. To control prices in the
economy, it is felt important to control wage increases.
Create a link between wages and productivity. A fairer method for controlling
inflation and setting wages is to try and link wage growth to productivity. This
incomes policy aims to overcome the market failure of monopoly power from
trade unions (or monopsony power of employers)
Problems of price and incomes policy
Government bureaucracy and government failure. Prices and incomes policy
assumes governments have the ability to know how much prices and incomes
should rise, but in practice, it is difficult to measure productivity and determine
optimal wage rise.
Limited ability to control wages. Government efforts to rein in wage increases
were only of very limited success. Voluntary agreements were generally ignored
and even statutory limits in some sectors made little overall impact on inflation
and wage increases.
Trade unions disliked incomes policies They felt that it prevented them from
getting higher market wages through collective bargaining. Also, incomes policy
has been criticised as being unfair as it is targetted at limiting the wage increase
of workers, but not limiting other forms of incomes, such as executive pay,
dividends, rentable income e.t.c.
Firms dislike incomes policies as it could be too generous to workers. Also, it
reduced flexibility for firms. In theory, firms could be fined if they paid workers
more than the legal wage rise.

Unfairness. It could be unfair to the lowest paid, who ended up with low wage
increases because productivity was hard to increase in that market. In a period of
high inflation, wage increases may be insufficient.
High inflation. Empirical evidence shows that inflation was high during the
1970s. This inflation was partly due to cost-push factors, out of the control of the
government, such as the oil price shock of the 1970s, but even so, the results
were tremendously disappointing with evidence that the government was unable
to control underlying inflationary pressures in the economy.

Monetarist critique. The monetarist critique was based on the fact that they felt
the underlying cause of inflation was excess growth of the money supply.
Therefore trying to control incomes and prices was dealing with the symptoms
rather than the cause. If the money supply was growing too fast, then incomes
and price policies were like whack a mole. The government could try to stop
inflation appearing by forcing wages down, but inflation still kept cropping up
elsewhere. Monetarists argued the government should leave prices and incomes
to the market and concentrate on controlling the growth of the money supply
through monetary policy and controls on government spending/budget deficit.

Political criticism. From the early 1970s, an increasing number of Conservative

MPs were supportive of the idea that Conservativism was incompatible with such
a strong sense of government intervention in the economy. The free-market
revolution of Milton Friedman and link between economic freedom and political
freedom became attractive to politicians such as Keith Joseph, Margaret
Thatcher.

Statutory restraint could lead to industrial unrest and trade unions resisted
proposed wage increase. The 1970s saw increased industrial unrest and
record numbers of days lost to strikes, suggesting that incomes policy was not
solving (or even contributing) to industrial unrest.