Theme 3

3.1.1 Why do some firms remain small

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• might get too specialised in areas becoming out of date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

Nash equilibrium

• All players pursuing their best possible strategy given the strategies of all other players

3.4.4 Collusion

• Occurs when firms operate together or collaborate to limit comp and divide market

• Two types:

• overt collusion - operating together openly - occurs if firm sends message to another firm about its prices/decisions - illegal

• tacit collusion - unspoken - illegal but hard to control

Why do firms collude?

• Remove cost of comp e.g marketing

• Interdependence - joint profit max - act together to maximise profits (use pay-off matrix to illustrate this)

• Successful collusion can increase SNP - increase producer surplus - increase shareholder value - increase share prices

• snp can also be used to R&D - dynamic efficiency

• Reduce uncertainty in market

• Protect market share/ dominance in market against rivals

Collusion in a market is easier to achieve when:

• There are small number of firms in industry and barriers to entry protect monopoly power of existing firms in LR

• Market demand isn't too variable of cyclical

• Demand fairly price inelastic so that a higher cartel price increases total rev to suppliers - easier when product is viewed as necessity

• Each firms output can be easily monitored - enables cartel to more easily control total supply and identify firms who are cheating on output quotas

Possible break downs of cartels

• Several factors can create problems within collusive agreement between suppliers:

• Enforcement problems - cartel aims to restrict production max profits - but each individual seller finds it profitable to expand production - may become difficult for cartel to enforce its output quotas - disputes about how to share profits

• other firms may opt to take free ride - producing close to but just under cartel price

• Falling market demand creates excess capacity in industry and puts pressure on individual firms to discount prices to maintain rev - collapse of coffee export cartel 2001

• Successful entry of non cartel firms into industry undermines cartels control of market - e.g emergency of online retailers in book industry led to Net Book agreement 1995

• Exposure of illegal price fixing by regulators

3.4.5 Monopoly assumptions

• One firm in market

• High barriers to entry/exit

• Firms aim to profit max

• Firms face downward sloping demand curve

• Imperfect info

• Differentiated (monopoly power)

• Price maker

Price discrimination

• When a firm charges different prices to different consumers for reasons that don't reflect cost differences

conditions of price discrimination

• Some degree of monopoly power with barriers to entry

• Separate target market into two different sub categories with differing elasticities - inelastic and elastic

• Prevent arbitrage (re selling) and cost of preventing this must be lower than increase in rev

Advantages of price discrimination

• Increase rev and make SNP - can use this increased rev to cross-subsidise - consumers more choice

• Allows them to manage demand

• Some consumer benefit from lower prices (elastic) - increase consumer surplus

• Increased SNP can be used for R&D / investment - dynamic efficiency

Disadvantages of price discrimination

• Costs to administer/ prevent arbitrage

• Some consumers pay higher prices - decrease consumer surplus - lower income groups may have to pay higher price

• May not reinvest SNP / could just give to shareholders

What is a natural monopoly?

• For NM, LRAC curve falls continuously over range of output - result may be that theres only room for one firm in market to fully exploit EoS available

• Key point is that it is characterised by increasing returns to scale at all levels of output - LRAC will drift lower as production expands

• LRAC is falling as LR marginal cost is below LRAC

• may only be room for one supplier to reach minimum efficient scale and achieve productive efficiency

• Example - Royal Mail postal distribution network - collection/sorting/delivery

Benefits of monopolies for consumers

• Innovation - may bring new ideas and take risk of new ideas not working

• R&D - large firms more able to plough back large sums into this high risk enterprise - research more often then not leads to failure

• Investment - large scale firms can invest - confident

• Cross-subsidisation may lead to increased range of goods/services

Benefits of monopolies

• SNP means:

• finance for investment to maintain competitive edge

• Monopoly power means:

• powers to match large overseas organisations - help keep jobs within country and improve bop

• Price discrimination may raise total rev to point which allows survival of product

• Monopolists can take advantage of EoS - AC may still be lower than the most efficient average of a small competitive firm

• Can avoid duplication of services - misallocation of resources

Benefits of monopolies for governments

• Large firms may pay higher rates of cooperation tax - more profit monopoly makes, more firm will pay in tax

• May have competitors outside country - monopoly power helps keep jobs within country and improves bop

Benefits of monopolies for workers

• May offer better job security

• Higher profits for firm may mean higher bonuses for workers

Benefits of monopolies for other firms such as suppliers

• Can offer secure outlet for suppliers

• Firms that buy from monopolies may be more likely to have constant quality - not worth taking risks with quality - too much to lose