theme 3 econ

reasons for firms wanting to grow

-profits

-costs, operating on a larger scale can lead to lower unit costs

-market power, larger firms more able to control markets and reduce competition

-reducing risk, if expanded into multiple different markets then minimised impact of one market or product becoming less profitable

reasons for firms operating on a smaller scale

-lack of finance for expansion

-avoids diseconomies of scale

-may be a monopoly

-supplies niche products, no reason to expand due to low PED for them, no need for business to expand to reduce unit costs

the divorce of ownership from control

-can occur when firms grow in size and become larger entities

-shareholders own the firm but appoint managers and directors to run it on their behalf

-shareholders want to maximise dividends by maximising profits

-managers may have different motives such as sales maximisation or revenue maximisation at the expense of profits

-may lead to the principle-agent problem, where the principle (shareholder) and the agent (manager) have divergent aims

-may result in the business growing larger than a firm which simply aims to profit maximise

public sector organisations

organisations owned and controlled by the state, their purpose is to provide a service to society

-making profit is not their main aim, aims may be providing services to the public, social or ethical objectives, value for money for taxpayers

-e.g NHS, education academies, local authorities

private sector organisations

-owned by individuals or other companies

-aim is almost always to make profit

-not-for-profit organisations are a part of this sector but dont have profit max as a main aim such as charities

-aims are profit, sales, rev max, survival, satisficing

organic growth

-internal growth

-when firms increase their output through internal methods such as using retained profit

integration

-external growth

-when 2 (usually larger) firms are brought together through a merger or takeover

-merger is when 2 or more firms join under one ownership

-takeover is when one firm buys another firm

vertical integration

-merger of 2 or more firms at different production stages within the same industry

-backward vertical integration is where a firm merges with a business operating at an earlier stage in the production line e.g bread manufacturer purchase wheat farm

-forward vertical integration is when a firm merges with a business at a later stage in the production process

horizontal integration

two firms at the same stage of production in the same industry merging with each other

conglomerate integration

-when two firms with no interests in common join together, could also be a takeover

-a conglomerate has a large number of diversified businesses

pros and cons of organic growth

-cheaper than external growth

-can be financed through internal funds rather than more expensive sources of finance

-allows a more sustainable rate of growth

-growth may be achieved dependent on the growth of the overall market and is therefore out of the firms control

-slow method of growth-shareholders may demand more rapid ones

pros of vertical integration

-can take advantage of some economies of scale such as financial economies, leads to lower prices for consumers

-reduces risk as firm has more control on market

-backward gives more control on supplies

-forward gives more control over prices it can charge

cons of vertical integration

-communication and coordination problems, leading to diseconomies of scale

-merging firms with different corporate cultures can have internal problems

-some workers may leave the firm if not happy or due to brain drain

pros of horizontal integration

-reduces average costs due to economies of scale

-reduces competition in the market, less competitors for the firm

-firm can grow in a market which they already have expertise in

cons of horizontal integration

-communication and coordination problems, leading to diseconomies of scale

-merging firms with different corporate cultures can have internal problems

pros of conglomeration

-reduces risk as firm is less dependent on one market

-easier to expand further due to access to finance

cons of conglomeration

-lack of expertise in new type of business

-consumers may not choose to use new firm as it has a different identity to the original firm

-shareholders do not always get good value for money as firms can overpay when buying a new business

constraints on business growth

-size of the market, small markets offer little opportunity for expansion

-access to finance, larger firms are better able to borrow money as they have more equity and pose less risk to lenders, smaller firms struggle to do this

-owner objectives, not every owner wants their firm to grow, firms with more than one owner may have disagreements which can limit growth opportunity

-regulation, intended to limit the growth of firms in certain sectors

demergers

firms choose to reduce their size of operation, either splitting off a business into a separate company or selling one or more businesses to another firm

reasons for demergers

-to maximise profits

-reduce the risk of diseconomies of scale, large organisations can suffer from rising unit costs due to the scale

-value, may be higher with the companies demerged than a single larger firm

-to create more focused firms better able to recognise what specific consumers or markets want

impact of demergers on businesses

-allows focus on the core business

-raises funds from selling part of the business

-removes loss making parts of the business

-increases efficiency/profitability

impact of demergers on workers

-increased job securty if loss-making parts removed

-reduced conflict between cultures

-split may lead to creation of new jobs in separated firm, however it could lead to losses in the original company

impact of demergers on consumers

-greater competition as more firms leads to lower prices or higher quality

-more focused more able to meet consumer needs

-could have a reduced product range

objectives of firms

profit, revenue, sales maximisation and profit satisficing

profit maximisation

-occurs when marginal cost = marginal revenue

-keeps shareholders happy

-reinvestment opportunities

-greater efficiency, lower costs, lower prices as trying to max profit

why a firm may not profit maximise

-may be unaware of where it’s MC = MR as marginal costs include opportunity costs

-greater risk of investigations which can be costly to firms, could be told to lower prices or up wages

-other objectives like sales max or survival

profit satisficing

-occurs when there is divorce of ownership of control

-conflict between stakeholders (groups who are influenced by what the company does) e.g shareholders vs consumers

revenue maximising

-occurs where marginal revenue is equal to 0

-goal to drive out competition in market with lower prices

-lower price and higher quantity

-may also benefit from economies of scale

sales maximising

-average costs equal average revenue

-selling the highest quantity possible

-short term objective to increase size of business

-fully allows for economies of scale

-managers salary linked to size of business

revenue

the money a firm earns from it’s sale of goods and services, there is total, average and marginal revenue

-TR is the income received from the sale of any given level of output

-AR is the average receipt per unit sold, must be the same as price

-MR is the income gained from producing an extra unit of output

revenue formula

TR= total quantity sold (Q) x average price (P)

AR= TR/Q

MR= %change TR/% change Q

TR when price is falling

-initially revenue increases due to increased output

-begins to fall as price falls and sales rise

AR and MR when price is falling

-both fall as sales increase

-AR curve is the same as the demand curve as demand shows the average revenue received at each level of output

revenue and PED

-when the price of a good falls, as sales increase there will be a change in the PED

-when PED is elastic an increase in price results in a fall in revenue

-when inelastic an increase results in a rise in rev

-when MR is positive demand is price elastic

-when negative price inelastic

-when price for a product is constant the demand curve, AR and MR curves will be the same and will be horizontal

costs

-costs of prod refer to the economic cost of producing the output, includes monetary cost of factors of prod and opportunity costs of prod

fixed costs- dont change as output changes

variable costs- change with output

total cost, total fixed cost and total variable cost

TC- cost involved in producing at a certain level of output

TFC- part of TC that does not vary with the level of output

TVC- part of TC that does vary with the level of output

average (total) cost, average fixed cost, average variable cost

AC- cost per unit produced, TC/Q

AFC- total fixed costs divided by number of units produced TFC/Q

AVC- total variable costs divided by number of units produced TVC/Q

marginal cost

-the cost of producing one more unit of output

change in TC/change in Q

the assumption of diminishing marginal productivity

-short run cost curves are derived from this

-also known as the law of diminishing returns, the assumption states that at a certain point increasing a variable factor of production will eventually lead to smaller output

-by increasing the use of a variable factor while another is fixed the marginal returns from the variable factor will begin to decrease

-the point at which diminishing marginal productivity sets in can be seen where the MC curve begins to rise

long run average cost curves

-all factors of prod are variable

-means the assumption of diminishing marginal productivity does not apply

economies of scale

the fall in the long-run average costs of production as output rises

-internal economies of scale occur when a firm increases the scale of production within the firm

-external economies of scale involve changes outside the firm, AC falls due to changes in the industry in which the firm operates in

types of internal economies of scale

-technical economies, improved production methods to reduce AC, can buy more efficient machinery

-managerial economies, large firms can employ specialist managers with expertise in certain areas, greater efficiency

-financial economies, ability of large firms to borrow money at lower rates of interest as they are seen less risky than small firms

-purchasing/marketing economies, large firms can buy in bulk, reducing AC

diseconomies of scale

-cause a rise in the long run average costs of production as output rises

reasons for diseconomies of scale

control, larger firms become more difficult to manage, may be harder to keep track of costs

communication, may be barriers to communication in larger orgs, may lower morale and productivity

co-ordination, becomes harder in larger firms to organise and co-ordinate activities of different staff and departments, lower productivity

profit

total revenue-total cost

normal profit occurs when the difference between TR and TC is 0, it is the profit needed by a firm to remain competitive in the market

MC = MR rule

-where MC meets MR on diagram is the profit maximising level of output

-if a firm increases output past this point the marginal cost of producing this extra output would be higher than the marginal revenue gained, leading to a decrease in overall profit

-the condition for profit maximisation

limitations of MC = MR

-assumes firms accurately know mc and mr, which is hard to figure out precisely

-does not consider how competitors will react, increasing output or price may lead to a response by competitors

-the effect of changes in price on QD might not be clear

supernormal profit

-or abnormal profit, where revenue generated from using factors of production is greater than it could have been if they had been used in another way

-on a diagram it is where MC = MR and lower line above AC curve to make a box of supernormal profit, as revenue higher than costs

losses and shut down points

-losses occur when a firms total costs are higher than it’s revenue

-if a firm does not make normal profit it will close in the long run because it is not covering all of it’s costs

-known as the shut down point

-in the short term the firm can accept some losses providing it can cover it’s variable costs

the effect of supernormal profits on the market

-where firms in an industry are making supernormal profits, new firms will have an incentive to enter the market

-will increase supply and should (ceteris paribus) lead to a lower market price

-the opposite is true if firms are making losses, more firms leave, reducing supply

productive efficiency

when production is achieved at the lowest average cost

-firm will be producing at the bottom of the AC curve where costs are lowest, AC and MC intersect

-for the economy as a whole there is productive efficiency if it is operating on its PPF

allocative efficiency

-when resources are distributed according to consumer preferences

-how resources are allocated

-an economy could be productively efficient on the lowest point of their AC curve but may not be producing what consumers want so no efficient allocation of resources

-found at the point where price = marginal cost

static vs dynamic efficiency

-static occurs at a particular point in time

-dynamic is concerned with productive efficiency of firms over a period of time, improving it in the long term

x-inefficiency

-refers to the inefficiency cause by a firm not minimising it’s average costs

-potential AC is lower (require a downward shift) than actual AC

-for larger firms diseconomies of scale may mean that it is harder to co-ordinate and control activities which leads to higher average costs than a more efficient firm

perfect competition

-lots of firms operating in a highly competitive environment , hypothetical structure although some markets show some of the characteristics of it

-no firm will make supernormal profits in LR although profits and losses to be made in SR

characteristics of perfect competition

-many buyers and sellers, no single firm influences market price

-perfect information

-homogenous products, all firms produce identical products, no branding or differentiation

-freedom of entry and exit, no barriers to enter/exit

-all firms assumed to be profit maximising (MC = MR)

monopolistic competition

-a market structure where a large number of small firms produce non-homogenous products and where there are no barriers to entry

-key diff between monopolistic and perfect competition is the production of non-homogenous products, making the demand curve (AR) downward sloping

-still many buyers and sellers and profit maximisers

oligopoly and it’s characteristics

-found towards the centre of market spectrum, described as a concentrated market

-high concentration ratio, small number of firms supply a large proportion of the market

-product differentiation, things such as branding

-high barriers to entry and exit, firms in oligopoly typically large, scale of operation is large deterring comp

-interdependence of firms, actions taken by one firm have an impact on others

concentration ratios

-level of domination in a market is measured by the concentration ratio

-ratio of combined market shares of a given number of firms : market size

-assesses the extent to which a given market is oligopolistic

-n-firm concentration ratio formula=

sum of market share of the number of firms/total size of market x100

uncertainty in oligopolies

-created because firms do not know how rivals will react

-market price that all firms charge, if one firm were to reduce prices they do not know how others will react

collusion

-way of reducing the risk of uncertainty

-involves collective agreements between firms that restrict comp

-this is illegal, restricts comp and is harmful for consumers

-overt collusion is formal, usually secret agreement between rival firms

-tacit collusion is where firms accept the decisions of a dominant firm

game theory

-can be used to predict how firms may behave, such as why they may collude and why collusive agreements break down

-the prisoners dilemma, both prisoners comitted a crime together and are held separatelt, been offered a deal to confess and implicate the other for a lower sentence while their accomplice gets 5 years, or both deny and get 2 each, so both plead guilty and take the lower sentence

-with firms they have the option of leaving the price unchanged or reducing it, they may leave it unchanged to avoid losses like the prisoners

-why oligopolists engage in non-price comp

price wars in oligopolies

firms don’t want to cut prices as they may start a price war

predatory pricing

when a firm sells a good/service at a price below cost (or very cheap) to drive other firms out of business when they enter the market

limit pricing

reducing the price to deter entry, less profit in short term as no supernormal but allows firm to retain monopolistic or oligopolistic position so beneficial in LR

types of non-price comp

-advertising

-loyalty cards and schemes, discounts to encourage repeat purchases

-branding

-packaging, differentiation

-better quality consumer service