Economics Theme 3 Flashcards
What are 6 reason firms may want to grow?
Profits: Bigger business –> More sales revenue –> Higher levels of profit
Economies of scale: Bigger business –> Can buy with lower costs, receive better interest rates etc…
Market share: Bigger business –> More sales in market –> More marke share –> More selling powers –> More profit
Diversification: Bigger business –> Higher profits –> Diversify product portfolio and enter new markets –> Spread risk across multiple markets and products –> Increase chance of survival
Managerial motives: e.g. larger salaries or increased leisure time (bigger businesses can hire managerial directors)
More security - able to build up assets and cash which can be used in financial difficulties
What are 4 reason firms may remain small?
Operate in niche markets – Some businesses may operate in a niche market and therefore don’t have sufficient demand for the goods/services that they sell for their business to grow
Barriers to entry – This may make it difficult for firms to expand into different markets and grow. e.g. some markets may be dominated by large businesses that have much lower operating costs than their business and can therefore offer a more competitive price
Small can be a selling point – e.g. local business support, closer customer service, more personal experience (customer and seller know each other)
Business objectives - Not always to grow/make money
What is the significance of divorce of ownership from
control?
Shareholders own the business and appoint directors and managers to
run it on their behalf. Shareholders want to maximise profits to maximise their
dividends, whereas managers might have different motives, such as wanting to
increase sales and revenue at the expense of profits. This divorce of ownership
creates the principal-agent problem.
What is the principal-agent problem?
As a business grows, the shareholders (principals) often appoint managers (agents) to run the business from day to day e.g. financial managers, sales managers etc
However, the managers may have different objectives from the shareholders
e.g the shareholders want to maximise dividends and therefore want the business to profit maximise. The managers may have objectives such as revenue maximisation.
The principal-agent problem stems from asymmetric information as the shareholders don’t always know how managers are behaving and what decisions they’re making.
In order to try and reduce this problem, some businesses may put in place schemes that help align the principal’s objectives with the agent’s.
e.g. if the owners were to give managers a percentage of the business’s shares, then the managers may switch their objectives from sales maximisation to profit maximisation. This is because they also want to maximise the dividends they receive.
What is the difference between public and private sector organisations?
Public sector organisations are run by the government e.g. the NHS.
Private sector organisations are run by private individuals and are therefore left to the free market.
Why are private sector firms usually more efficient than public sector organisations?
Private firms that are constantly making a loss are likely to become bankrupt as they need to make a profit in order to survive in the free market. This means that unlike public organisations, private firms have a profit motive. This encourages private firms to be as efficient as they possibly can in order to survive and to make a profit, whereas public organisations don’t have this incentive as they act in society’s interest and do not face competition.
What is the difference between profit and not-for-profit organisations?
Not-for-profit organisations have a main objective that differs from profit, such as helping the local community.
They are exempt from certain taxes that for-profit firms have to pay. The profits that not-for-profit firms make will go towards their main objective which will help to improve society, but they may not make a profit.
Profit organisations have profit as their main aim, and they oftenmake decisions that are in their own self-interest and may have a negative impact on society, but are profitable to make.
What are the 5 ways a business can grow?
Organic growth
Horizontal integration
Forwards vertical integration
Backwards vertical integration
Conglomerate integration
Organic growth definition
Organic growth is where a business grows internally by reinvesting profits or
borrowing from banks.
Vertical integration definition (and difference between forwards and backwards)
Vertical integration is where two businesses at
different stages of production, but in the same industry, join together.
Forward vertical is where a firm integrates with a firm in a stage of
production closer to the customer in the same industry.
Backwards vertical is where a firm integrates with a firm in a stage of
production further away from the customer in the same industry.
Horiontal integration definition
Horizontal integration is where two businesses at the same stage of
production in the same industry join together.
Conglomerate integration definition
Conglomerate integration is where two businesses in different industries
merge.
What are some examples of organic growth?
Subway, Wasabi, Poundland, Hotel Chocolat
What are some examples of vertical integration?
Forward:
Vehicle manufacturer buys a car retail business
Fishing business buys fish and chips shop
Backward:
Book shop buys a publishing company
Coffee shop buys a coffee bean supplier
Vodafone / Mannesmann (mobile and broadband service buys electronics and steel manufacturer)
What are some examples of horizontal integration?
Supermarket merger
Northern Rock and Virgin money (banks)
Pfizer and Warner-Lambert merger (developing and selling in the pharmaceutical indsutry)
What are some examples of conglomerate integration?
Amazon and Ring
Amazon and Twitch
What are 2 advantages of organic growth?
Reduced risk – The main advantage of growing organically is the reduced risk of enduring any of the detrimental effects that may occur during mergers and takeovers e.g. a clash of business cultures.
Helps to avoid diseconomies of scale – By growing organically it allows the business to grow at a more sustainable pace. As a result of this, there is less chance of the business experiencing increased costs as a result of diseconomies of scale.
What are 2 disadvantages of organic growth?
Slow growth – By growing organically it will take longer for the business to increase its market share, by which point their competitor that has grown through a merger/takeover may be dominating the market.
Less competitive - If other businesses merge, they experience economies of scale, allowing them to lower their prices and become more competitive.
What are 3 advantages of vertical integration?
Guaranteed supplier or outlet for product
Greater control over supply chain – Can make more efficient to reduce costs, or make changes to increase quality
Impacted less by varying levels of demand – Can easily increase or decrease supply when necessary
What are 2 disadvantages of vertical and horizontal integration?
Potential diseconomies of scale
Culture clash
Whare are 3 disadvantages of conglomerate integration?
Lack of knowledge - Entering a new market can be extremely risky if the business owner does not have experience or expert knowledge of the market. As a result of this, they can may make poor decisions and are unable to attract new customers or may even lose existing customers.
Culture clash
Potential diseconomies of scale
What are 3 advantages of horizontal integration?
Economies of scale
Reducing competition - greater market power, potentially a monopoly
Spreading risk - if failed investment for example, costs are spread over the entire business, which is now bigger. Has a lower impact on profits.
What is an advantage of conglomerate integration?
Reduces risk - diversification. The business no longer has to rely on the performance of one market alone
What are 4 constraints on business growth?
Size of the market
Access to finance
Owner objectives – Principle-agent problem
Regulation
Why is the size of the market a constraint on business growth?
Businesses may operate in small or niche markets, meaning that the demand for their goods/services will be limited. As a result of this, there is little room for the business to expand.
Larger markets have a much wider scope for innovation, and firms can take
advantage of huge selling opportunities.
Why is access to finance a constraint on business growth?
It is more difficult for smaller businesses to access finance. They are unlikely to be making supernormal profits, and the risk of investing in them is higher for banks and other lenders as they aren’t yet well-established. As a result, they either won’t be able to access finance, or will have a high interest rate.
Why are owner objectives a constraint on business growth?
The business owner may not have the objective of growth. For example, instead they may aim for corporate social responsibility. By doing so they may increase their costs of production, thus reducing their profit and ability to grow. Short-terminism can take place too (profits in the short run at the expense of long-term growth)
Why is regulation a constraint on business growth?
Excessive regulation (red tape) can limit the quantity of output of a firm (e.g. environmental laws and taxes might result in firms only
being able to produce a certain quantity before exceeding a pollution permit).
Excessive taxes, such as a high rate of corporation tax, might discourage firms
earning above a certain level of profit, since they do not keep as much of it. This
might limit the size that a firm chooses, or is able to, grow to.
Demerger definition
A demerger is when a business sells off one or more of the businesses that it
owns into a separate company.
What are 6 reasons for demergers?
Cultural differences
Creating more focused firm (Mergers can often result in the business losing focus of its key aims and objectives)
Protect value of firm (remove loss making parts)
Reduce risk of diseconomies of scale
Raise finance
Meet requirements of competition authority
regulators
(A business is broken into two or more
components, either to operate on their own, to be sold or to be dissolved)
What are 3 impacts of demergers on the business itself?
Allows to focus on the core business - more efficient and innovation
Raises funds
Removes loss-making parts of the businessn - higher profits
What are 2 impacts of demergers on workers?
Increased job security if loss-making parts of the business are demerged
Reduced culture conflict - more motivated
What are 2 impacts of demergers on consumers?
Better products and cheaper prices (efficiency and innovation, increased competition now smaller)
What are the 4 different business objectives?
Profit Maximisation
Revenue Maximisation
Sales Maximisation
Profit Satisfising
Why do firms have an objective to promit maximise?
Private firms have a profit motive because the assumption of rationality means that shareholders will seek to maximise their utility by maximising profits, and therefore dividends. Other influences on the business, such as owners, directors and managers may also have a profit motive if their salary is directly or indirectly influenced by the level of profit.
Why might firms have an objective to sales or revenue maximise?
Managers are sometimes paid a salary that is linked to the number of sales or amount of revenue the firm achieves.
More sales increases market share for the firm, which enables them to experience greater economies of scale in the long run, so that the firm can lower costs, and therefore lower price.
Lowest possible prices increases brand loyalty and attracts new customers. This may also push rival firms out of the market as they can’t compete with such low prices and are losing customers. In the long-run, with high market share, the firm will then be able to raise prices with a more inelastic demand, and therefore increase profit.
If the firm has a social or political aim, they will sales maximise to spread their message to as many people as possible.
Why might firms have an objective to profit satisfice?
Managers and directors may be motivated by high salaries, the number of people under their
control or the availability of fringe benefits, as these will increase their utility more than profit maximising. However, if they ignore profit, shareholders can revolt and may vote them out. So firms may profit satisfice where they satisfy the demands of shareholders whilst being free to maximise their rewards from the company.
E.g: Working fewer hours to enjoy more leisure time; behaving ethically.
Profit Satisficing definition:
When a firm makes a level of profit below profit maximisation that satisfise the needs of the shareholders of the firm.
Where is profit maximisation?
MC = MR
Where is revenue maximisation?
MR = 0
Where is sales maximisation?
AC = AR
Formula for Total Revenue:
Price x Quantity
Formula for Average Revenue:
Total Revenue / Quantity
(also Price)
Formula for Marginal Revenue:
Change in Revenue / Change in Quantity
- When demand is elastic, increasing price will:
- When demand is elastic, decreasing price will:
- When demand is inelastic, increasing price will:
- When demand is inelastic, decreasing price will:
- Total Revenue decrease
- Total Revenue increase
- Total Revenue increase
- Total Revenue decrease
Formula for Total Cost:
Total Fixed Cost + Total Variable Cost
(also Average Cost x Quantity)
Formula for Total Variable Cost:
Average Variable Cost (Variable Cost per Unit) x Quantity
Formula for Average Total Cost:
Total Cost / Quantity
Formula for Average Fixed Cost:
Total Fixed Cost / Quantity
Formula for Average Variable Cost:
Total Variable Cost / Quantity
Formula for Marginal Cost:
Change in Cost / Change in Quantity
Short Run definition:
A time period when at least one of a firm’s factors of production are fixed.
Long Run Definition:
A time period when all of a firm’s factors of production are variable.
Why is there diminishing marginal productivity in the short run?
In the short run there is at least one fixed factor of production. The law of diminishing marginal productivity states thatadding more units of a variable input
to a fixed input, increases output at first. However, after a certain number of inputs are added,
the marginal increase of output becomes constant, and then when there is an even greater input,
the marginal increase in output starts to fall. In the long run, all factors of production are variable.
What is the difference between internal economies of scale and external economies of scale?
Internal economies of scale: A decrease in average costs as a result of an increase in the scale of the production of a firm.
External economies of scale: A decrease in average costs as a result of an increase in the scale of production within the industry in which the firm operates.
What is the minimum efficient scale?
The point of lowest LRAC is the minimum efficient scale. This is where the optimum
level of output is since costs are lowest, and the economies of scale of production
have been fully utilised.
What are the 7 types of economies of scale?
Technical
Purchasing
Marketing
Managerial
Financial
Distribution / Network
Risk-Bearing
Explain technical economies of scale.
Large-scale businesses can afford to invest in expensive and specialist capital machinery that increases efficiency and decreases average costs, as they can spread fixed costs over high output. The businesses also have more money to spend on R&D.
For example, a large supermarket can invest in technology that improves stock control, but this would not be cost-efficient for a small corner shop.
Explain purchasing economies of scale.
Large firms can buy in bulk and achieve purchasing discounts.
For example, supermarket chains can buy fresh fruit in much greater quantities than a small fruits and vegetable supplier, and at discounted rates.
Explain marketing economies of scale.
A large firm can spread its advertising and marketing budget over a large output, and can purchase its inputs in bulk and at discounted prices.
For example, Amazon or Virgin can advertise multiple products at the same time and with the same studio.
Explain managerial economies of scale.
Large-scale businesses have the money to employ specialist labour (e.g. accountants, lawyers, technical experts), and to use division of labour to make production more efficient. They can employ managers to supervise these systems and oversee human resources.
Explain financial economies of scale.
Large-scale firms are usually rated by financial markets to be more credit worth as there is less risk involved for them. This gives the firms access to credit facilities, with favourable rates of borrowing. Small firms often face high interest rates on overdrafts and loans, or struggle to access credit at all.
Explain distribution / network economies of scale.
When a large-scale firm introduces new products, they can make use of existing distribution and supply networks.
Explain risk-bearing economies of scale.
When a firm becomes larger, they can expand and diversify their production range.
Therefore, they can spread the cost of uncertainty. If one product is not successful, they
have other products to fall back on.
Economies of scale definition:
The advantages enjoyed by a business as output increases and average cost decreases.
Diseconomies of scale definition:
The disadvantages experienced by a business as average cost increases as a result of output increasing.
What are the 3 main types of diseconomies of scale?
Communication
Coordination
Control
Explain communication diseconomies of scale.
Larger firms find it more difficult to communicate efficiently within the organisation and thereare increased communication costs.
Managers of small firms find it easier to communicate with all members of the workforce.
Workers may also start to feel alienated and excluded as the firm grows. This could lead to a fall in productivity and increases in average costs, as they lose their motivation.
Explain coordination diseconomies of scale.
Larger firms find it more difficult to manage the increased number of personnel and customers as they grow.
It might become increasingly difficult to delegate and motivate workers.
Processes become less efficient, which increases average costs.
Explain control diseconomies of scale.
It becomes harder for a firm to monitor how productive and motivated employees are as the firm gets larger and employs more workers. Workers may become lazy if they are not being monitored, as the risk of being made redundant increases.
If the firm decides to employee managers to prevent this, this is a large increase in fixed costs. (However, could lead to managerial economies of scale).
What is the significance of supernormal profit?
It creates an incentive for firms to increase production and for new firms to enter the industry.
It is a reward for production that can benefit shareholders in the form of dividends and workers in the form of pay.
It can be used to reinvest, such as R&D, which results in dynamic efficiency.
Corporation tax is paid on profits, which creates significant revenues for the government.
Supernormal profit definition.
When total revenue exceeds total costs
Normal profit definition.
When a firm’s total revenue is equal to their total costs.
Subnormal profit / loss definition.
When a firm’s total revenue is lower than their total costs.
Where is the short-run shut-down point? Why?
AVC = AR
When AR is above AVC, some of the revenue can go towards paying fixed costs, therefore decreasing the loss the firm is making.
Where is the long run shut down point? Why?
ATC = AR
Every additional unit of output where ATC > AR creates a loss. Firms require normal profit to operate in the long run.
What is the significance of normal profit?
Normal profit is the minimum reward required to keep entrepreneurs
supplying their enterprise in the long run. It covers the opportunity cost of investing
funds into the firm and not elsewhere.
Allocative efficiency definition.
When society is producing goods to match the needs of consumers. Quantity supplied is equal to quantity demanded and consumer satisfaction is maximised.
Productive efficiency definition.
When minimum inputs are used to produce maximum outputs at the lowest cost.
Dynamic efficiency definition.
Where firms improve efficiency in the long run by investing in R&D or production process.
X-inefficiency definition.
When firms produce at a given output higher than the potential minumum cost.
Why might firms be X-inefficient? What type of market structure?
Firms, particularly monopolies, sometimes feel complacent due to the lack of competition, so have little incentive to reduce waste and minimise costs.
Uncontestable markets, monopolies, lack of competition, lack of regulation.
May also be due to: organisational slack, a waste in the production process, poor management, laziness.
Where is allocative efficiency?
AR = MC
Where is productive efficiency?
AC = MC
Where is dynamic efficiency?
AR > AC
Where is X-inefficiency?
Anywhere above AC (not on the AC curve)
Which types of efficiencies in which market structures:
Allocative efficiency
Productive efficiency
Dynamic efficiency
X-inefficiency
Perfect competition
Monopolistic competition
Oligopoly & Duopoly
Monopoly
Perfect competition: Allocative efficiency, Productive efficiency
Monopolistic: None
Oligopoly & Duopoly: Dynamic efficiency
Monopoly: Dynamic efficiency, X-inefficiency
What are the 4 characteristics of perfect competition? Explain them.
Many buyers and sellers, none of whom are large enough to influence price.
No barriers to entry and exit to and from the industry
Buyers and sellers possess perfect knowledge of the market
Homogeneous products
What is the significance of there being no barriers to entry and exit in perfect competition?
There are no or very few entry costs, such as capital expenditure and research and development costs.
There are no or very few sunk costs, such as advertisements.
What is the significance of there being homogeneous products in perfect competition?
Buyers can’t tell the difference between products from different firms. There is no branding, brand loyalty or marketing and advertising.
What is the significance of buyers and sellers having perfect knowledge of the market in perfect competition?
Buyers and sellers have a comprehensive understanding of all factors within a market (e.g. prices and availability).
Firms produce the same quality output as they use the same processes as other firms.
What is the significance of there being many buyers and sellers in perfect competition?
Because there are so many, no one buyer or seller is large enough to influence price. Firms are price takers, and all charge the same price. All firms make normal profit because if a firm makes supernormal profit, there will be an incentive for new firms to enter the market, who will increase supply in the market, increasing the price (AR curve), and if a firm makes a loss, they will be forced out of the market.
What are the 3 characteristics of monopolistic competition?
Large number of small firms
Low barriers to entry and exit
Firms produce similar, but differentiated products
What profit levels do firms in perfect competition and monopolistic competition make in the short run and long run? Why?
Short Run - Supernormal profit and losses
Long Run - Normal profit
In the long run,supernormal profits will be eroded because new firms will enter the market owing to a lack of barriers to entry. The entry of new firms will increase supply, shifting the average revenue curve downwards to the point where AR=AC, as in the diagram. If the firm was making a loss, it would leave the industry, reducing supply and shifting the AR curve upwards again to a point where AR=AC. Therefore, in the long run, a firm in monopolistic competition can make neither supernormal profits nor losses.
What are the 4 characteristics of an oligopoly?
High barriers to entry and exit
High concentration ratio
Interdependence of firms (the actions
of one firm will impact other firms in the industry)
Product differentiation
Oligopoly definition.
An oligopoly is a market dominated by a few large firms. They are interdependent and therefore either compete or collude.
A market with a high firm concentration ratio.
