business behavior (paper 1) Flashcards
what are the reasons why some firms remain small?
1) existing firms with large market power. Due to their dominance, firms with monopoly power will have price setting power, which could be used to discourage new firms from entering the market or to grow. They may even have monopsony power which means they’re able to bargain for lower prices of raw materials, etc. For example: the NHS is the main buyer of drugs in the UK. Existing firms who are well established in the market already have great brand loyalty and a large customer base. it maybe hard trying to attract customers of your own if the largest firms are already so well known.
2) limited access to credit - smaller firms may be less likely to receive large enough loans from banks, as they are deemed riskier investment than a pre-existing firm looking to expand. Large firms are more likely to have to pay back a smaller amount of interest as they are viewed more stable.
3) no aspiration to grow. Some smaller businesses maybe content with their size and the lifestyle it provides, so they may not see the benefit in growing anymore if they’re already satisfied with their company’s size. For example: a family-owned bakery.
what are the reasons why a firm may grow?
Operating in a niche market. This is where there’s only a small amount of customers looking for your specific good, yet it’s extremely profitable as people are after your expertise and are willing to pay the higher prices.
Diversification. By expanding your product range, firms reduce their risk of making a loss, as they have other areas within the market to fall back on. For example, a company that produces wheels for cars may start to also produce windows too.
Prioritizing revenue maximization in the short run rather than profit. This is a simple way of increasing your customer base, as your typically low prices will entice customers to switch to you. This will increase your market share, and once a body of customers has been generated you can start to profit maximise.
what is the principal agent problem? (divorce of ownership from control)
including how such problem could be tackled
As firms grow, the owner will hire managers to run the business for them in different areas of the country, etc. There is a divorce between who owns the company and who runs it then. This creates the problem where owners and managers have conflicting interests. For example: shareholders wanting to maximise profits, yet managers wanting to maximise their salaries, or sales for that day so they can make a bonus.
This problem is exacerbated by information gaps – where the managers have a lot more information on the day to day running of the company in comparison to the owners. The managers can also control what information reaches the owners.
Evaluation: one-way owners aim to tackle this, is by giving their staff shares in the company, this will unite a shared want to profit maximise rather than any other objective. For example, the CEO may be partly paid in dividends rather than a salary, or the staff may all have their own small shares in the company - like John Lewis.
what is the difference between a public and private sector organisation?
public sector organizations – owned and controlled by the government. Their goal is not to maximize profit, instead it’s to provide a service - and thus maximise utility. For example, the NHS.
Private sector organizations – owned and controlled by private individuals. The goal of most private organizations is to maximise profit.
what is the distinction between a profit and not for profit organisation?
Both profit and not-for-profit organisations are found in the private sector, they are not owned by the government but rather private individuals in the market.
A “for profit” organisation is your average firm that wans to maximise profit in the market. For example: adidas.
However a not-for-profit organisation will still need to make some profit in order to survive in the market, yet its ultimate goal is not to profit maximise, but rather to provide a service for the public / utility maximise. For example, the British heart foundation. Many sell goods (like charity shops) and use the profit made to further advance in their objective/goal.
what is organic growth?
Organic growth – when a business expands its own operations without relying on a merger or takeover. Their growth is internal. It is achieved through re-investing your own profits to grow. This can occur through:
-Investment in capital or tech that increases their capacity
-Using marketing to attract a larger customer base
-Launching new products to attract new attention
-Borrowing money from the bank to open a new store
what are the advantages to organic growth?
1) It is less risky than a merger. The growth is financed by profit and the majority of mergers end up failing.
2)The pace of growth is manageable. You have the ability to plan ahead as the outcome is more predictable.
3) you maintain control - maintains existing management and culture, not need to compromise with another companies ethics.
what are the disadvantages to organic growth?
1) The growth id very slow, as it is mainly financed by profit made in previous years (or equally small loans made by the bank)
2) makes it harder to compete with other firms in the market who have grown through mergers - and have the benefit of greater expertise, human capital, economies of scale, etc.
3) Harder to benefit from internal economies of scale as your scope of production is likely to be smaller and reliant on other manufacturers, etc. for certain stages of production. this means the “middle man” company will also be making a profit - profit your company is now missing out on.
3) limited access to credit in the beginning stages - for the bank to loan to a smaller firm just starting up, this is a riskier loan than loaning to a pre-established firm with market presence, as it is less clear if such smaller firm will be able to pay it back as well. whereas companies who are already experiencing economies of scale and have more promising figures of turnover, etc, will be able to access more credit / funding.
what is vertical integration?
where a firm buys another firm in their supply chain. This can be either forwards or backwards.
-forwards: a car manufacturer buying a car dealership. They are moving forward to the end product.
-backwards: a clothes store buying a sweatshop. They are moving back down the supply chain.
what are the advantages to vertical integration?
1) reduces the cost of production as the middleman’s profits are eliminated. For example, the cost of shipping your product to the seller.
^you absorb the once profits - for example, the farm would’ve been making a profit on the milk they’ve sold to the ice cream place. You now absorb this profit yourself.
2)Better control over the quality of the product, if it’s backwards integration. For example: watering or feeding your plantations with more care than the previous company will lead to better crops.
3) can increase brand visibility, which makes it easier for businesses to distinguish themselves and gain loyal customers.
what are the disadvantages to vertical integration?
1) This can create barriers to entry for other new, potential firms wanting to enter the market. For example, if Nike owns a shoe factory they’ll charge more for other companies to use it.
2)Possibly little expertise in that specific field. For example, an ice cream company won’t know how to milk a cow. This may result in inefficiencies. Evaluation: it is more likely that the firm buying the new firm will keep on the majority of that firm’s workers, as they’re aware they will have more expertise than training new staff.
3) there may be a culture clash between the two companies. Existing employees will have existing ethos and expectations that the other company merging may not agree with. (like standards surrounding breaks, pay, etc.)
what is horizontal integration?
Horizontal integration – where a firm merges or takes over with another firm at the same stage in production. For example: Nike buying adidas.
what are the advantages to horizontal integration?
1) rapid increase of market share, reducing competition and possibly allowing negotiation power with companies below the supply chain.
2)Economies of scale will lead to a reduction in cost making the final product more profitable.
3) existing knowledge of the industry means the merger is more likely to be successful from two experts coming together.
what are the disadvantages to horizontal integration?
1) there can be a cultural clash between the two companies. For example, each firm will have their ethos and way of doing things. Disagreement may occur over standards of pay, holiday, breaks, pensions, etc.
2)Diseconomies of scale may occur. For example, being reluctant to make workers redundant during the initial merger, duplicating managers roles in the process to not upset anybody.
^managerial diseconomies of scale
^communicational diseconomies of scale
3) You’re still limited to one market. If market conditions change you have nothing else to fall back on as you’re fully committed. Equally, the CMA is likely to get involved.
what is Conglomerate integration?
a merger or takeover of a firm in an entirely different market. For example: John Lewis (retail) and Waitrose (supermarket).
what are the advantages to conglomerate integration?
1) reduces overall risk of business failure. If your company owns companies in multiple markets, you can fall back on your other companies if market conditions change in one specific industry. For example last year John Lewis made a loss of 4% yet Waitrose made a profit of 5% so overall the company made a profit of 1%.
2)If you’re already a big firm the CMA may block any horizontal growth, therefore conglomerate growth is another way to ensure you still grow without annoying the CMA.
what are the disadvantages to conglomerate integration?
1) possible lack of expertise in this new market
2)A culture clash
3) Diseconomies of scale - either firm maybe reluctant to lay off their own workers. This may lead to both communicational diseconomies of scale yet also managerial diseconomies of scale.
what are the constraints on business growth?
The size of a firm
A niche market will have limited opportunities for business expansion as it requires a certain taste for their products to sell. This is due to their limited customer base. However, larger firms will have a wider scope for innovation and a larger customer base in order to help grow.
Diseconomies of scale
As a firm gets larger, they may begin to experience diseconomies of scale rather than continue to grow at such a fast rate.
Access to finance
Smaller firms new to the market tend to have less access to finance than larger, well-established firms. This is because they’re viewed as riskier by the banks since the 2008 financial crisis. Without access to credit, firms cannot invest and grow as much.
Owners’ objectives
Some owners may have different objectives to others. Some may aim to maximized welfare, others may have an environmental impact in mind when making decisions, or some may simply want to maximize profits.
Regulations
Excessive regulation can limit the quantity of output that a firm produces. For example, environmental laws like pollution permits limit the amount of greenhouse gases a company can emit. Also, excessive corporation tax discourages firms from making huge profits as they don’t keep much of it.
what is a demerger?
when a firm sells off one part of the company or splits itself into two or more separate firms again.
what are the reasons for a demerger?
-cultural differences
-reducing diseconomies of scale
-complying with the demands of the CMA
what are the impacts of demergers on both the consumer and workers?
on workers – some may be made redundant. However, there may now be a better team dynamic if the reason the demerger happened was due to a culture difference. Thes people may see an opportunity for promotion as positions may start to open up.
On consumers – customers will have more variety now in the market as there has been an increase in competition. this may lead to lower prices in the long-run.
what is the business objective to profit maximise?
draw diagram
This is known as the rational business objective, and is the underlying assumption of neo-classical economics. profit maximisation occurs where marginal cost MC = MR marginal revenue on the diagram.
^if MR is bigger than MC, additional profits can still be made by producing another unit. yet if MC is bigger than MR, you are now making a marginal loss.
the profit made is supernormal profit.
what are the limitations to having profit maximisation as your business objective?
- in the real world it is very hard for a business to work out what their MC and what their MR is. This is especially hard because it is difficult to know the PED for a good, which effects the MR.
- in the short-term firms may not want to change their price as soon as MC changes, as this becomes confusing for consumers. Instead they may choose to absorb some of these higher marginal costs themselves, and thus sacrifice their profit maximising level of output.
what is the business objective to revenue maximise?
draw diagram
revenue maximisation occurs where MR = 0. At this output profit is still being made, but not the maximum level of profit.
Revenue maximisation can occur due to the principal agent problem. occurs when the agent makes decisions on behalf of the principle, which leads to them often placing their own agenda above the principle’s agenda. For example, the principal may want to maximize profit to pay off their dividends, however the agent may want to maximize revenue to reach their targets and get a bonus, etc. firms that look to revenue maximize are more likely to use price discrimination to extract extra revenue from consumers.
why may a firm want to revenue maximise instead?
Maximize revenue in the short term – this will increase output and allow firms to benefit from economies of scale. Therefore, firms may revenue maximise to break into a market, or even eliminate competition as their price is lower than when focusing on profit maximization. For example, amazon looked to maximize revenue in the short-run in order to become more competitive in shipping, etc. This led to many other shipping companies shutting down as amazon were not looking to make a profit initially, and therefore their prices were lower and more competitive.
what is the business objective to sales maximise?
draw diagram
where AC = AR. At this output, normal profits are made. This will make you just enough profit to stay in the industry.
If you maximize your sales your market share may grow, making you a more dominant firm in the industry. This will create a higher output, yet sold at a lower price.
^firms may use this in the short-term to clear excess supply, like during a sale. This means they sell remaining stock without making a loss per unit.
^ or small family run businesses may seek to sales maximise in order to bring in a profit all while surviving in the market. They may not have the aspirations for profit maximisation, or accountancy skills to find this equilibrium.
what does it mean if your business objective is to satisfice?
satisfies examine only a limited range of alternatives and then use a general rule of thumb rather than complex pricing strategies. They’re aware of their limited information and market knowledge and know their is time involved in finding the optimum pricing point for everything. They just work out their costs and then add a little bit of profit on to find their price. As long as they make a sufficient rate of return, then they’re happy. They are therefore striving for satisfactory profit, rather than maximizing it. This can occur in small businesses like a bakery or corner shop, where they just want enough profit for a means to live.
what is meant by total revenue, and what is the equation for it?
total revenue is the total amount of sale s a firm makes. it is price times quantity sold.
what is meant by average revenue, and what is the equation?
average revenue is the overall revenue per unit. the equation is total revenue divided by quantity.
the AR curve is the firms demand curve. this is because it is the price of the good. (assuming it is a competitive market)
what is meant by marginal revenue, and what is the calculation for it?
the extra revenue received from the sale of the last additional unit sold.
the equation is: change in total revenue divided by change in quantity.
when MR = , revenue is maximized
what is the relationship between PED and revenue?
PED measures how responsive demand is to a change in price. Whereas total revenue is price times quantity.
Therefore if a firm can figure out what the PED of their product is, then they can maximise revenue.
If PED of their product is price elastic, then they should reduce their price of their product - this will maximise total revenue. A change in the quantity demanded will be larger than the change in price.
However if the PED for their product is price inelastic, then they should raise the price of their product - this will maximise total revenue. This is because the change in price will be larger than the change (fall) in demand.
what is meant by a fixed cost?
A fixed cost is a cost that cannot change in the short-run. As output changes, the fixed cost remains the same.
For example:
-loan repayments
-insurance
-rent
^None of these factors change when the level of output changes. They are fixed. Yet they can be re-negotiated in the long-run.
what is meant by variable costs?
costs that vary with the level of output. for example: the cost of raw materials, workers wages, amount of machinery, etc.
All costs are variable costs in the long-run.
what is meant by marginal costs?
what is the equation?
the cost of producing an additional unit of output.
change in total costs divided by change in quantity
what is the difference between a short-run cost curve and a long-run cost curve?
(include the relationship between short-run AC curves and long-run AC curves)
short-run costs: a period of time where at least one factor of production is fixed. for example, it is difficult to change the amount of factories you own in the short-run, yet this can be changed in the long-run.
long-run costs: the period of time in which all factors of production are variable factors. this is known as the planning stage as firms can plan for an increase in capacity and thus production.
The long-run cost curve is made up of multiple previous short-run cost curves. The SRAC decreases over time, and therefore when a firm enters a new short run cost curve, it is lower than the previous. This can be illustrated on a diagram.
what is meant by the law of diminishing marginal productivity?
In the short-run, as more variable factors are added to fixed factors, there will be an initial increase in productivity, yet soon diminishing marginal productivity will occur.
The shape of the SRAC is determined by the law of diminishing marginal productivity.
^The marginal cost is larger than the average cost - this is what causes the SRAC curve to rise, creating its U shape.
^For example, imagine an ice cream van that currently employs only 1 worker. This worker has to take the orders and make the ice creams. If you were to employ another worker, division of labour could occur, and therefore an increase in productivity. However once you employ a third worker, it is unclear what work is left for them. Instead they may stand idle and get in the way. In this sense, the more variable factors you add (labour) to a fixed factor (the ice cream van) the more diminishment there will be in productivity.
what is the relationship between the short-run and long-run average cost curves?
Short-run: at least one factor of production is fixed in the short-run. Day to day operations take place at this output.
Long-run: all factors of production are variable factors. This is known as the “planning stage” as the firm can plan to increase their capacity / output.
^Once more output is generated, the firm can move into a new SRAC, in which the AC will be lower. In the long-run, firms will repeat this process, generating a more efficient SRAC curve as economies of scale occur.
what does economies of scale mean?
as a firm increases its output in the long-run, its long-run average cost will start to decrease - this is the economies of scale.
The same amount of inputs results in more outputs than previously.
what does increasing returns to scale mean?
an increase in inputs result in a larger increase in output. This is why the AC curve slopes down to begin with.
what does diseconomies of scale mean?
However as a firm continues increasing its output in the long-run, its average costs will begin to increase - this is the diseconomies of scale
what are the 3 types of economies of scale?
- financial economies of scale - as firms grow bigger, the more access to credit they will have. this is because banks will be more willing to lend to them, as they’re more likely to pay it back - therefore the loan is less risky for the banks. Greater access to credit enables to funding for greater innovation and technological advancement.
^They may even receive lower interest rates on their loans as they’re less risky. - purchasing economies of scale - larger firms have greater access to credit, and therefore can afford to buy their raw materials in bulk. known as bulk buying. bulk buying reduces the cost of each unit overall. these firms, due to the mass amount they are purchasing, have a lot of bargaining power over the suppliers. This is because their trade will make up a great proportion of the suppliers income, and therefore it is in the suppliers best interest to engage in such negotiation.
- technical economies of scale - as firms grow, they may re-invest profits (or take out loans) to invest in more advanced, better quality capital - that is ultimately more productively efficient and cost saving. This capital maybe specialist, and produce more units of output with each input - returning economies of scale. Equally, it may just produce better quality products.
what are the 3 types of diseconomies of scale?
- geographical diseconomies of scale - occurs when a firms area of operation is widely spread out, which leads to logistical and communication challenges. it may cost a lot to ship, language barriers, time zone differences, etc.
- communication diseconomies of scale - occurs when a firm has multiple layers of management, and decision making must go through more people than necessary, making decision making longer than it needs to be - thus less efficiency.
- management diseconomies of scale - occurs when managers work in their own self interest, rather than in the interest of the firm - managers can become territorial.
what is the minimum efficient scale?
the minimum efficient scale represents the lowest possible cost per unit that a firm can achieve in the long-run. it is the lowest point on the AC curve. at this point they will be experiencing constant returns to scale - increase in inputs leads to a proportional increase in output. if it continues to grow beyond this point, they will start to experience diseconomies of scale.
what is an internal economies of scale?
Internal economies of scale refer to the cost advantages that a single firm can achieve as it grows in size and expands its production capacity
what are the 3 examples of an internal economies of scale?
- financial economies of scale - larger firms receive lower interest rates on loans as they’re deemed less risky, and more likely to pay it back.
- purchasing economies of scale - when a larger firm buys raw materials in a bulk, they receive a discount on it. equally, larger firms have more bargaining power - if you’re a large business buying a large stock, you have more negotiating power to bargain the price down. for example, the NHS buying drugs.
- technical economies of scale - larger businesses can afford t invest in expensive and specialist capital machinery.
what is an external economies of scale?
occurs when there is an increase in the size of the industry that the firm belongs to / operates in
what are the 3 examples of an external economies of scale?
- geographical cluster - as an industry grows, firms that use a specific manufacturer move closer to where they are situated to cut costs and generate more business. For example: Reading is well known for its tech industry.
- transport links - improved transport links develop around growing industries in order to help get people to work / mobility of labour and improve the movement of materials / goods.
- favourable legislation - costs fall as the government supports certain industries and their objectives - for example the film industry in Bristol and Bath is growing due to a removal of taxation limitations that were previously present.
what is the difference between normal profit and supernormal profit?
normal profit - where total revenue and total costs equal . this is called the break even. You are making just enough to stay in the market.
Supernormal profit - where total revenue is greater than total cost. This occurs when firms have a level of market power and can set the price.
when should a firm shut down in the short run? (draw diagram)
Firms should shut down in the short run when AR = AVC.
^At this point the firm can fund its AVC, yet no contribution is being made towards their fixed costs. They are therefore making a loss.
diagram
when should a firm shut down in the long-run? (draw diagram)
Firms should shut down in the long-run if AC is larger than AR.
^They are making a loss in the long-run, and therefore should shut down. However, if this was in the short-run they should remain open, as AR is larger than AVC still.
diagram
