A level economics Edexcel Theme 3

Why do firms grow?

1) To experience Economies of scale —> decreases cost of production, make more revenue by selling more units. Make larger profits 

2) Greater market share —> ability to influence prices and restrict the ability of other firms to enter the market, helping them to make more profits in the long run. Monopoly power often means firms have monopsony power, and so will be able to reduce their costs by driving down the prices of their raw materials

3) Security: a larger firm will have more security as they will be able to build up assets and cash which can be used in financial difficulties. Able to spread risk by selling a bigger range of goods and in more than one local/national market. 

Explain the principal agent problem

• when the agent makes decisions for the principal, but the agent is inclined to act in their own interests, rather than those of the principal. 

• When an owner of a firm sells shares, they lose some of the control they had over the firm. This could result in conflicting objectives between different stakeholders in the firm. If the manager is particularly good, they might require higher wages to keep them in the firm. However, they also need to keep shareholders happy, since they are an important source of investment. It is not always possible to give both the manager a high salary and the shareholders large dividends, since funds are limited.

What is a public sector organisation?

• when the government has control of an industry e.g. NHS

• there can be natural monopolies in the public sector

• some public sector industries yield strong positive externalities e.g. public transport—> pollution reduced

• main objective is to maximise social welfare

What is a private sector organisation?

• when a firm is left to the free market and private individuals

• private sector gives firms incentives to operate efficiently, which increases economic welfare.

• firms have to produce the goods and services consumers want, which increases allocative efficiency —> goods may also be of higher quality

• competition also results in lower prices

• main objective : profit maximisation

What’s the difference between profit and not-for-profit organisations?

• profit organisation aims to maximise the financial benefits of its shareholders and owners. the goal is to maximise profits

• a not-for-profit organisation has a goal which aims to maximise social welfare, they can make profits, but cannot be used for anything other than this goal and operation of the organisation

What is organic growth?

• when firms grow by expanding their production through increasing output, widening their customer base, developing a new product or diversifying their range

• Firms might use market penetration to sell more of their products to existing consumers.

• They might also invest in research and development, technology, or production capacity. This will allow sales to increase and the volume of output to expand.

What are the disadvantages of organic growth?

• slower than growing organically, it is a long term strategy —> means competitors can gain more market power by expanding in the meantime —> makes shareholders unhappy if they want faster growth 

• less innovative ideas

• Firms might rely on the strength of the market to grow, which could limit how much and how fast their can grow.

What are the advantages of organic growth?

• Less risky than organic growth

• Firms grow by building upon their strengths and using their own funds, such as retained profits, to fund the growth. This means that the firm is not building up debt, and the growth is more sustainable

• r, existing shareholders retain their control over the firm, which might reduce conflicts in objectives that are possible when there is a takeover. ( clash of cultures ) 

What are the different forms of integration?

• forward vertical

• backward vertical

• horizontal 

• conglomerate 

What is vertical integation?

Vertical integration occurs when a firm merges with or takes over another firm in the same industry, but a different stage of production.

What is forward vertical integration?

• when the firm integrates with another firm closer to the consumer. This involves taking over a distributor. For example, a coffee producer might buy the café where the coffee is sold.

What is Backward vertical integration?

when a firm integrates with a firm closer to the producer. This involves gaining control of suppliers. For example, a coffee producer might buy a coffee farm.

What are the advantages of forward/backward vertical integration?

• firms can increase efficiency, through gaining economies of scale, reducing average costs → this could result in lower prices for consumers

• Firms can gain more control of the market. Backwards integration can mean that firms can control the price they pay for their supplies, and they could raise the price for other firms. This could give them a cost advantage over their competitors

• Firms have more certainty over their production, with factors such as quality, quantity and price.

Forward integration:
Removes retailer profit → ↑ profit | More control → ↑ brand power |

High costs → ↑ risk | Diseconomies possible

Backward integration:
Removes supplier profit → ↑ profit | Stable inputs → ↓ uncertainty |

Expensive → ↑ risk | Less flexible

What are the disadvantages of forward/backward vertical integration?

• the firm may have a lack of expertise and they now need to manage additional retail/ supplier operations —> lead to inefficiencies —> diseconomies of scale

• Vertical integration can create barriers to entry, which might discourage or limit the entrance of new firms. This could lead to a less efficient market ( X- efficiency ) , since the firm has little incentive to reduce their average costs when their market share is high.

What is horizontal integration?

• the merger of two firms in the same industry and the same stage of production

What are the advantage and disadvantages of horizontal integration?

advantages:

• firms can grow quickly —> competitive advantage over other firms

• firms can increase output quickly, so they can take advantage of economies of scale

• both firms have expertise in the same industry

• disadvantages:

• potential for monopoly power —> could lead to lower inefficiency 

• disagreement of objectives between two firms 

What is conglomerate integration?

This is the combining of two firms with no common connection

What are the advantages and disadvantages of conglomerate integration? 

advantages:

Potential for financial synergy → excess cash in one division can fund growth in another

• It can help both firms become stronger in the market, than if they were individual.

• The conglomerate can reach out to a wider customer base, and market competition could be reduced.

• The advantages of economies of scale, and particularly risk bearing economies of scale

disadvantgaes:

• lack of expertise

• There is a risk of spreading the product range too thinly, and there might not be sufficient focus on each range. This might reduce quality and increase production costs.

What are the constraints on business growth?

• size of market

• access to finance

• owner objectives

• regulation ( red tape )
  

What are the reasons for demergers?

• Lack of synergies : synergy is when creating a whole company is worth more than each company on its own, without this firms will demerge because they will be worth more

• Growth: Each part of the firm could grow at different rates. The faster growing part might be separated.

• diseconomies of scale

• focussed companies: : The firm might be able to grow faster if it focuses on a few markets, rather than several.

• Resources: If a firm can no longer afford to invest the business, due to a lack of resources, they might sell off a part.

• Finance: Selling off part of the firm can raise valuable finance, which could be better invested in a more profitable part of the firm.

What are the impacts of demerges on businesses?

• firms can dispose of underperforming or loss- making parts of the firm —> allows the new demerged firm to focus on core activities

• firms might be able to eliminate diseconomies of scale

• firms can make profit by selling off part of a firm . this can also be used as a source of finance

what are the impacts of demergers of scale of workers?

workers can face job cuts 

What are the impacts of demerges on consumsers? 

• lower prices for consumers —> due to removal of diseconomies of scale

• increased choice for consumers when a horizontally integrated firm demerges

What is profit maximisation?

• occurs when marginal cost = marginal revenue (each extra unit produces gives no extra costs or no extra revenue 

Why would firms profit maximise?

• It provides greater wages and dividends for entrepreneurs 

• Retained profits are a cheap source of finance, which saves paying high interest rates on loans

• In the short run, the interests of the owners or shareholders are most important, since they aim to maximise their gain from the company. 

• Some firms might profit maximise in the long run since consumers do not like rapid price changes in the short run, so this will provide a stable price and output

What is revenue maximisation?

• occurs when MR = 0

• each extra unit sold generates no extra revenue

What is sales maximiation?

This is when the firm aims to sell as much of their goods and services as possible without making a loss.

• maximises market share

Not-for-profit organisations might work at this output and price. On a diagram this is where average costs (AC) = average revenue (AR).

What is profit saticficing?

A firm is profit satisficing when it is earning just enough profits to keep its shareholders happy.

Shareholders want profits since they earn dividends from them.

Managers might not aim for high profits, because their personal reward from them is small compared to shareholders. 

therefore, managers might choose to earn enough profits to keep shareholders happy, whist still meeting their other objectives.

This occurs where there is a divorce of ownership and control.

What is allocative efficiency?

• when resources are distributed to the goods and services that consumers want

• maximises utility

• exists at P = MC

• free markets are considered allocatively efficient

What is productive efficiency?

• when firms produce goods/services at the lowest possible cost

• resources are used in the most efficient way possible

• producing maximum output and minimum input

What is dynamic efficiency?

• supernormal profits needed

• where all resources are allocated efficiently over time, and the rate of innovation is at optimum level, which leads to falling long run average costs

• through investment

What is X - inefficiency?

• when firms operate at higher costs than necessary

• could be due to organisational slack, a waste in the production process, poor management, or simply laziness

•  Monopolies tend to be x-inefficient, since they have little incentive to lower their average costs because of the lack of competition they face.

What are the characteristics of perfect competition? 

• Many buyers and sellers

• Sellers are price takers

• Free entry to and exit from the market

• Perfect knowledge

• Homogeneous goods

• Firms are short run profit maximisers

• Factors of production are perfectly mobile

What are the advantages of a perfectly competitive market?

• In the long run, there is a lower price. P =MC, so there is allocative efficiency

• Since firms produce at the bottom of the AC curve, there is productive efficiency.

• The supernormal profits produced in the short run might increase dynamic efficiency through investment.

What are the disadvantages perfectly competitive markets?

• in the long run, dynamic efficiency might be limited due to the lack of supernormal profits.

• Since firms are small, there are few or no economies of scale.

• The assumptions of the model rarely apply in real life. In reality, branding, product differentiation, adverts and positive and negative externalities, mean that competition is imperfect.

What are the characteristics of a monopolistically competitive markets

• large number of buyers and sellers

• no barriers to entry/exit ( allowing hit and run competition)

• differentiated, non-homogenous goods

• Each seller has the same degree of market power as other sellers, but their market power is relatively weak.

• Since firms have a downward sloping demand curve, they can raise their price without losing all of their customers. This is because firms have some degree of price setting power

• imperfect information

However, there are a lot of relatively close substitutes. This makes the XED of the goods and services sold high.

What efficiency do monopolistic firms have?

• not allocatively or productively efficient

• likely to have dynamic efficiency → to invest in differentiated products. however, difficult to receive finance or retained profits needed to invest

What are the characteristics of oligopolies?

• products are differentiated

• high concentration ratio

• firms are interdependent

• barriers to entry

What is the N-firm concentration ratio? How do you calculate it?

• measures the percentage of the total market that a particular number of firms have

• N = the number of the biggest firms in the market e.g. the 3 biggest firms so n = 3

• formula: ( total sales of n firms/ total size of market ) x 100

What is collusion?

• when firms make collective agreements that reduce competition

• when firms don’t collude, this is a competitive oligopoly

why may firms collude?

• firms can maximise industry profits

• reduces the uncertainty firms face and reduces the fear of engaging in competitive price cutting or advertising which would reduce industry profits

• collusion works best when there are a few firms all well known, firms are not secretive about costs and production methods, similar products, dominant firm others are happy to follow , market is relatively stable, there are high barriers to entry

Why may firms not collude?

• it is illegal

• A firm with a strong business model and something that sets it apart from other firms will not want to collude if they feel they can increase market share and/or charge higher prices than competitors.

What are the two main types of collusion?

overt: when firms come to a formal agreement, ( cartel), rules will be laid out in a formal document which may be legally enforced → fined charges for those who break the rules

tactic: there is no formal agreement

How can a cartel operate ( two ways )

• agree on a price for the goods, then compete freely using non-price competition to maximise market share

• agree to divide up the market according to the present market share of each business

What are the problems with a cartel

• no firm is likely to set their prices/output at the level they would not ideally choose and there is a constant temptation to break the cartel

what are the ways in which tactic collusion can operate?

• Price leadership is where one firm has advantages due to its size or costs and becomes the dominant firm. Other firms will tend to follow this firm because they would be fearful of taking on the firm on in any form of price war. As a result, the dominant firm will decide the price and allow the other firms to supply as much as they wish at this price.

• Barometric firm price leadership is where a firm develops a reputation for being good at predicting the next move in the industry and other firms decide to follow their leader.

• Other examples could be unwritten rules about keeping advertising low or not trying to take each other's customers.

How can the behaviour of a non-collusive oligopoly be determined?

• Game theory

What is game theory?

Game theory explores how one firm reacts to changes in strategy by a rival

What are the key strategies of game theory?

• Maximin — choose the strategy where the worst possible outcome is the least bad (risk-averse)

• Maximax — choose the strategy with the best possible outcome (risk-seeking)

• If both strategies produce the same solution → called the dominant strategy (rare in real life)

What’s the Nash equilibrium?

• Where neither player can improve their position given the other player's decision

• Both firms have optimised their outcome and have no incentive to change behaviour unless the rival does first

How can game theory explain why prices are stable in an oligopoly?

• Firms typically adopt the maximin strategy → keeping prices unchanged is the least bad option

• Raising prices risks losing customers if rivals don't follow; cutting prices triggers a price war

• Both firms end up leaving prices unchanged → Nash equilibrium → explains price stability in oligopoly

What is the prisoner’s dilemma?

• Two suspects kept apart and unable to communicate

• Dominant strategy = confess (best reward and least bad outcome individually)

• However if they could collude, both denying = Nash equilibrium and the best collective outcome

• Links to oligopoly — firms may want to collude but self-interest leads to individually rational but collectively worse outcomes

What is the key evaluation of game theory?

• Game theory assumes firms act rationally, but in reality firms may have incomplete information about rivals' strategies, limiting its real-world accuracy

what are the types of price competition?

• price wars

• predatory pricing

• limit pricing

What are price wars?

• These occur in markets where non-price competition is weak; where goods have weak brands and consumers are price conscious. They also occur when it is difficult to collude.

• A price war will drive prices down to levels where firms are frequently making losses. In the short term, firms will continue to produce if their AVC is below AR but in the long run, they will leave the market and prices will have to rise since supply falls.

• It lowers industry profits.

What is predatory pricing?

• This occurs when an established firm is threatened by a new entrant or if one firm feels that another is gaining too much market share.

• The established firm will set such a low price that other firms are unable to make a profit and so will be driven out the market. The existing firm is then able to put their price back up.

• This is illegal and only works when one firm is large enough to be able to have low prices and sustain losses.

What is limit pricing?

• In order to prevent new entrants, firms will set prices low (the limit price). The price needs to be high enough for them to make at least normal profit but low enough to discourage any other firm from entering the market.

• The greater the barriers to entry, the higher the limit price. It is mainly used in contestable markets.

• The drawback of this is that it means firms cannot make profits as high as they would otherwise be able to.

What are the types of non-price competition?

• advertising

• loyalty cards

• branding

• quality

• customer service

• product development

What efficiency do firms in oligopolies have?

• statically inefficient

• likely to be dynamically efficient, however some may share its profits with its shareholders or decide not to invest

• exploit economies scale, lowering costs

What are the characteristics of a monopoly?

• one firm is the sole seller of a product in a market

• has more than 25% market share

what are the conditions needed for third degree price discrimination?

• The firm must be able to clearly separate the market into groups of buyers;

• the customers must have different elasticities of demand;

• they must be able to control supply and prevent buyers from the expensive market from buying in the cheaper market.

what are the costs and benefits of third degree price discrimination?

pros:
- able to increase their profits, can go into R&D → improving dynamic efficiency

• those in the elastic market gaim as they are able to pay a lower price → beenft from cross subsisation

• - increases equality

• consumers lose some consumer surplus ,and some need to pay higher price