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3.1.1 Why do some firms remain small
Niche market - demand for product specialised and limited
Lack of economies of scale/avoid diseconomies of scale - firm has a small minimum efficient scale
Owner objectives
Why some firms want to grow
Economies of scale - larger firms have lower costs per unit of output in LR
Increased market share - larger firm has more market power - can control prices and retain consumer loyalty - competition reduced
Economies of scope - larger less exposed to risks of smaller firms
Psychological factors - more job satisfaction working for well-known brand
The principle-agent problem
Shareholders own most large businesses (principle) - appoint managers to control business on their behalf (agent)
Shareholders want to maximise profit but managers may have different objectives - increase sales and revenue at expense of profit
Private sector firms
Have to make profit to survive - primary objective is to make profit
Public sector firms
Can survive without making profit as gov can make up any shortfall in revenues
3.1.2 Organic (internal) growth
Firms grow from within - buy new capital, take on more workers
Advantages - low risk and easiest form of growth to manage
Disadvantages - firm might not take on new ideas/people
might get too specialised in areas becoming out of date
External growth
Firms grow by buying out other firms - merging or taking over
Disadvantages - may get too large and hard to control (diseconomies of scale)
Horizontal Integration
Firms merge at same stage of production process
Advantages of horizontal integration
Economies of scale
Increased market share
Reduced competition
Removes risk of being bought out
Disadvantages of horizontal integration
Focus of risk on narrow range of goods/services
Diseconomies of scale
Some workers may loose jobs - roles in new bigger firm duplicated
Workers may have to move/travel
Assets may be sold off - duplicated equipment
Vertical Integration
Firms merge at different stages of the production process
Backward vertical integration
One firm buys another that is closer to the raw material stage of production
Advantages of backward vertical integration
Control over raw materials - supply guaranteed
Other firms prevented from getting supplies
Supplier's mark up can become profit for buying the firm
Disadvantages of backward vertical integration
Firm might not need to buy all the supplies
Might not have specialist knowledge of production
Might find it hard to adapt to changes in consumer demand
Forward vertical integration
Buying a firm closer to the customer in the same stage of production
Advantages of forward vertical integration
Consumers will see firm's product at its best
Consumer might not be distracted by competition
Conglomerate integration or diversification
Occurs when a firm buys another firm in a completely unrelated business
Advantages of conglomerate business
Spreads the risk - profitable areas can cross-subsidise loss-making areas
Different products do well at different parts of business cycle
Brands become better recognised
Disadvantages of conglomerate business
Lack of expertise in new areas
Brands might become diluted
Constraints on business growth
Size of market - some firms could increase output but would have to drop price considerably or not find market at all
Access to finance - since credit crisis 2008 - been hard for small/medium size businesses to borrow and other forms of finance limited
Owner objectives such as control - some firms like to 'keep it in the family' - avoid employing people outside family - may make firm easier to manage and workers may have greater incentive/loyalty
Heavy gov regulation
3.1.3 Demergers
Business decides to split into two separate firms
Reasons for demergers
To focus on core business - develop that part to gain benefits of specialisation
Raise finance by selling shares in new company
Avoid diseconomies of scale - merged firms can be difficult to manage if involve different activities or too large
Impact of demergers
On businesses - long term - higher returns/profits as cost savings made
short term - financial cost of selling off one or more firms
On workers - expected job losses due to process of rationalisation
opportunities for managers of newly demerged business to increase sales
new jobs created and increased job security - loss making parts of business removed
On consumers - impact on consumer prices depends on intensity of competition and cost of economies of scale - higher unit costs in LR
3.2.1 Profit maximisation
MR=MC
Reasons for a firm to profit maximise
SNP are used for reinvestment
Dividends for shareholders
Reward for entrepreneurship
Disadvantages of profit maximisation
Calculating MC and MR in real world is difficult
Day to day decisions are taken on basis of estimated demand - firms may adapt cost plus pricing
Consumers sensitive to fair/ethical prices
Revenue maximisation
MR=0
Firm cuts its prices down to the point where extra revenue received from selling another unit is balanced by the reduced price on items it is already selling
Reasons for firms to revenue maximise
If a firm is going to have to dispose stock, costs aren't relevant
Wishes to deter profitable entry of new firms - maintain more market power
Ensure the business remains competitively priced in competitive market
Gain more benefit from economies of scale
Sales maximisation
AR = AC
Firm sells as much as possible so that is at least makes normal profit
Might increase market share and get rid of competitors by cutting price
SR policy - in LR firm might return to profit max
Reasons for firms to sales maximise
Increased market share increases firms monopoly power and enables them to increase prices - make profit in LR
Avoid attraction of competition authorities
Avoid attracting other firms into market
Satisficing
Making enough profit to keep shareholders happy, after which managers can aim for other objectives
Characteristics of the manager will be reflected in objectives of the firm
Firms may wish to keep profits down to avoid being taken over - managers may gain satisfaction from being in control
Some firms aim to make just enough profit to keep shareholders happy then pursue other objectives
3.3.1 Revenue
Amount of money received from selling goods and services
Total revenue
price x quantity
Price maker
Firm that has to cut its price in order to sell more
Price taker
Has to offer its product at the same price as everyone else
Average revenue
Price the firm receives per unit sold
TR/Q = P
AR = P
Marginal revenue
% change in TR/ % change in Q
3.3.2 Costs in the short run
At least one factor of production is fixed
Fixed costs
A cost that doesn't change with output e.g rent
Variable costs
A cost that changes with output e.g raw materials
Total costs
Fixed costs + variable costs
Average fixed costs
TFC/Q
Average variable costs
TVC/Q
Average costs
TC/Q
Marginal costs
Additional cost to the firm of making one more unit of output
% change in TC/ % change in Q
The law of diminishing marginal returns
As more variable factors are added to a fixed factor, the increase in output will eventually fall
Only applicable in the SR when at least one factor of production is fixed
3.3.3 Costs in the long run
All factors of production are variable
As theres no fixed costs, there can't be law of diminishing returns
Economies of scale
Occur when average costs per output fall as scale of output increases
Managerial economies
Both large and small firms have just one person at top
While manager of bigger firm may earn more, there is likely to be duplicated costs when two smaller firms combine to become one big one
Larger firms can afford better managers - higher profits and long-term sustainability
Financial economies
Larger firms have access to wider range of credit than smaller firms and at lower price
Large firms can issue shares on stock market and do deals to borrow at cheaper rates
Often seen as safer bet for loans - more assets that can be sold to pay off debt
Commercial economies
Large firms can bulk buy from their suppliers
As they buy a large amount at steady rate - better deals
Technical economies
Doubling dimensions of an object increases volume by 8 times - larger warehouse/shop can carry much more
Marketing economies
As firm grows bigger, cost of advertising spread out over large number of potential customers
Minimum efficient scale
At the point where LRAC are at their minimum, the minimum efficient scale of output of firm is reached
No further economies of scale can be achieved beyond this point
Affects number of firms that can operate in market and structure of markets
Diseconomies of scale
Occurs when average unit costs of production increase beyond certain level of output
Unwieldiness - large firms can become difficult to manage - decisions take longer to implement and person making decision may not have required knowledge
Slowness - takes large firm long time to respond in many cases
X-inefficiency - lack of comp for large firm may mean costs are allowed to rise
Lack of communication
Lack of engagement - management may become distant from worker - workers become less loyal - more absenteeism
External economies of scale
Sometimes industry as whole grows - individual firms can benefit from this growth
However, as industry grows, external diseconomies of scale may set in - difficult for firms to be notices
3.3.4 Profit
Reward for risk taking
Revenue - costs
Profit max
Occurs at the output level where supernormal profits are at their greatest
When MC = MR, no more profit can be made - MP = 0
Normal profit
The minimum necessary to keep risk-taking resources in their current use
Occurs when AC=AR or TC=TR
Doesn't act as signal for other firms to enter or leave market
Supernormal profit
Profit above the minimum required to stay in business
It is the difference between TR and TC
Losses
Occurs when a firms total costs exceed revenues - TC>TR
Firm doesn't automatically shut down when making a loss
Point where P = AVC or below = shut down point
3.4.1 Efficiencies
Efficiency measures how well resources are used to help satisfy changes in wants and needs
Static efficiencies (at point of time) - productive, x-inefficiency, allocative
Over time - dynamic efficiency
Productive efficiency
Concerned with producing goods/services with the optimal combination of inputs to produce maximum output for minimal costs
Producers are minimising wastage of resources
Occurs where firm operates on lowest average cost - lowest point of average cost curve
However, little incentive for firm to operate at productive efficiency and no incentive to lower price this far
Occurs where price = MC = AC as MC always closes AC at lowest point
X-inefficiency
Occurs when firm isn't producing at lowest possible cost for given level
Happens when costs rise because there is no comp
Main causes:
monopoly power
state control
Allocative efficiency
Occurs where P = MC of production
Means people are paying exact amount it costs to produce the last unit
If people are prepared to pay more than it costs to produce last unit it would be better in terms of consumer satisfaction to produce more units - consumers prepared to pay more than cost to society
However, if consumer satisfaction is less than cost of making unit, production should be cut back
Dynamic efficiency
Concerned with whether resources are used efficiently over time
Measures a firms ability to improve productivity over time such as by innovating, investing in humans capital or taking risks
Focuses on changes on amount of consumer choice available in markets together with quality of goods/services available
Overview of market structures
Concentration ratio - measures market share of nth largest firms
E.g 3 firm ratio - market share of 3 largest firms
Don't include 'others' in calculation
Highly concentrated - few large firms - dominate market
Low concentration - many small firms/market share diluted
3.4.2 Perfect competition characteristics
Many buyers and sellers - can't influence price - price takers
No barriers to entry or exit
Perfect knowledge
All firms aim to maximise profit - MR=MC
Firms making a loss
Firms will start leaving industry, prices will rise, output will rise for the individual firm as there's fewer firms in market
Allows MC to rise as MR rises
Firm may not shut down straight away - perfectly competitive firm will have fixed costs in SR
If the firm more than covers its AVC, we can say its making a contribution to FC of production
If it can't cover its AVC, its better to shut down straight away
3.4.3 Characteristics of monopolistic competition
Some price setting power - price makers - AR curve downwards sloping
Many buyers and sellers
Low barriers to entry/exit
All firms aim to maximise profit - MR = MC
Imperfect knowledge - asymmetric info
Type of product - similar but differentiated
3.4.4 Oligopoly assumptions
Few firms dominate market
High barriers to entry/exit
Firms aim for profit max - MR = MC
Firm faces downward-sloping demand curve
3.4.4 Oligopoly
Imperfect competitive industry with high level of market concentration
Rule of thumb - oligopoly exists when top five firms or fewer in market account for more than 60% total market sales
There is strategic interdependence - meaning one firms output and price decisions are influenced by likely behaviour of competitors
Competition in Oligopolies
With only few firms dominating, firms tend to avoid price comp
Non price competition
Use kink demand curve to show why prices are sticky and price comp seen as futile
Non price comp key to market share and profitability
Pricing strategies
Sales max pricing
Price wars
Limit pricing
Rev max pricing
Price discrimination
Predatory pricing
Price leadership
Non pricing strategies
Quality and innovation
Free gifts
Product development
After care/customer service/ warranties
Packaging
Advertising
Pricing strategies - predatory pricing
Involves cutting prices below average cost of production
Short term measure only and once other firms have been forced out of market the firm raises prices again
Almost always illegal
Pricing strategies - price wars
Occur when price cutting leads to retaliation and other firms cut prices - original firm again want to cut prices to increase their sales
Pricing strategies - limit pricing
Involves cutting price to point where new possible entrants or newly entered high cost firms can't compete
The incumbent firm can sustain this position in long term as it has lower costs
May or may not be illegal - depends on specific case
Pricing strategies - price leadership
In some markets dominant firm acts to change prices and others will follow
As if other firms try to make changes this could set off price war or other sorts of retaliation
Large firm becomes established leader
Pricing strategies - non-price competition
When firms take action to compete without changing price
May be through advertising, loyalty cards, free gifts
Evaluation of strategies
How successful is it likely to be?
Will rivals be able to copy strategy?
Will firms get a 1st - mover advantage?
How expensive is it to introduce the strategy? - if cost of implementation is greater than pay off - will be rejected
How long will it take to work?
Game theory
Study of strategies used to make decisions
Pay off matrix
Two-firm, two-outcome model
Dominant strategy
Unique best strategy regardless other players actions