Theme 3 Flashcards
Business size can be measured by:
-Market share
-Profit (growth or absolute)
-Employees/ outlets
-Market power
-DIversification (risk spread)
Economies of scale
Refer to the cost advantage (average cost falling) experienced by a firm when it increases its level of output
Diseconomies of scale
Occur as average costs start to rise beyond a certain level of output
Principle- Agent problem
-Refers to the divorce of ownership between the principal and agent
- ie shareholders and managers have different objectives which might conflict. Managers might choose to make a personal gain, such as a bonus, rather than maximise the dividends of the shareholder. (to fix this managers could be given shares in the business)
Public sector business
Controlled by the government e.g. schools, hospitals, libraries, (TAX)
Government (or state) has control of an industry, such as the NHS. Many industries in UK were nationalised after 1945 (railway, coal, electricity, steel)
A number of these were natural monopolies. For example, only one firm will provide water because it is inefficient to have multiple sets of water pipes.
Public sector industries have different objectives to private sector industries. Social welfare or industrial strategy might be a priority of a public sector industry.
Private sector business
Aim to make a profit, from small local businesses to large businesses
Free market economists will argue that the 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 and might mean goods and services are of a higher quality.
Competition might also result in lower prices. This is because firms operating on the free market have a profit incentive, which public sector firms do not.
Why do businesses grow
-Shareholder pressure
-Increase profit
-Increase market share
-New locations
-Survive
-Innovation
-Gap in market
-Achieve economies of scale
-Meet demand
-Managerial objectives like sales bonuses
-Synergy effects- new revenue streams
Organic Growth
Refers to a business growing gradually with their own resources
Methods of organic growth
-New customers- opening a new outlet or store
-New products- developing a new range of products
-New markets- - e.g. finding customers in a different location- Tesco tried to open in the USA, it was a flop
-Franchising- e.g. allowing other businesses to trade under your name (Subway, McDonald’s)
Organic Growth Advantages
-Lot less riskier than inorganic growth- cultures, practises, the way they do things are all established.
-Much cheaper than inorganic- can be financed through retained profit rather than borrowing or raising share capital.
-Retain Capital
-Less likley to experience diseconomies of scale
Organic Growth Disadvantages
-Slow pace of growth- might be hard to keep shareholders happy- they want high returns quick.
-May get left behind if rivals are all growing inorganically
-Cant tap into knowledge and expertise of other businesses as would be the case with inorganic growth.
Two Types of External Growth( inorganic)
-Merger- two businesses join together for mutual benefit.
-Takeover/ acquisition- one business acquires another along with all its assets. Can be hostile or voluntary.
Horizontal Integration
Merging or taking over a business at the same level of the supply chain, or in same industry at the same stage of production. It can create economies of scale and sharing expertise (synergies). For examples in 2019, The Walt Disney Company acquired 21st Century Fox’s entertainment assets in a deal that marked horizontal integration in the media and entertainment industry. The acquisition included film and television studios, cable and international TV businesses, and various other assets.
Forwards vertical Integration
Occurs when a company expands its operations by acquiring or controlling businesses that are closer to the end consumer or the distribution side of the supply chain. Allows businesses to determine how products are promoted and build relationships with consumers. For example : In 2017, Amazon, an e-commerce and technology giant, acquired Whole Foods Market, a high-end grocery store chain. This acquisition was a forward vertical integration move for Amazon, as it allowed the company to enter the brick-and-mortar retail space and expand its reach into the grocery industry.
Backwards vertical integration
With backward vertical integration, a company acquires or takes control of businesses positioned earlier in the production or supply chain.
By doing so, the company aims to ensure a stable and reliable source of raw materials, reduce dependency on external suppliers, and achieve cost savings through economies of scale.
It also means that business dont have to pay extra (profit margins) to suppliers.
For example, a car manufacturer may backward integrate by acquiring a steel manufacturer to secure a supply of steel for their car production.
For example, Nike owns its own factories, which gives it more control over the production of its shoes & apparel. Nike also owns its own retail stores, which gives it more control over the distribution of its shoes.
Tesla use forward and backwards vertical integration.
Conglomerate
A conglomerate has acquired many diversified businesses. It takes over businesses in a different market, spreading risk.
The world’s biggest conglomerates include businesses such as 3M in the United States, Siemens from Germany and Philips (Netherlands).
Samsung – the South Korean electronics giant - makes military hardware, apartments, ships and is also operates an amusement park.
Advantages of inorganic growth
-Greater profitability
-Market share and assets become larger
-Additional skills and expertise of new staff
-Easier to obtain capital when needed
Disadvantages of inorganic growth
-May be additional debt acquired
-Possibly large upfront cost
-Management challenges with integrating acquisitors
-More regulation (Asda/Sainsbury’s got stopped)
-Resistance to chnage
Vertical integration
Vertical integration is a business strategy where a company expands its operations by acquiring or controlling other businesses that are either upstream or downstream in the supply chain.
This means that a company integrates different stages of production or distribution within the same industry under its ownership.
The main goal is to gain more control over the entire value chain, from raw materials to the final product or service delivery.
There are two types of vertical integration – backward and forward
Adv of forward vertical integration
-Increased market power: A company can gain more control over distribution channels and access to final customers. This can increase market power and bargaining position with retailers or distributors.
-Enhanced control over distribution: Forward integration allows a company to have control over how its products are distributed and displayed to customers. This can lead to better brand representation, consistent messaging, and improved customer experiences.
-Profitability: By cutting out distributors, a company can capture a larger portion of the value chain, leading to higher profit margins on its products.
Benefits of vertical integration
-Control of the supply chain – this helps to reduce unit costs and improve the quality of inputs into the production (supply) process
-Improved access to key raw materials perhaps at the expense of rivals who must then pay more for them
-Better control over retail distribution channels + adding new channels to sales platforms to build business revenues
-Removing suppliers and taking market intelligence away from competitors which then helps to make a market less contestable (it increases a firm’s market power)
Drawbacks of vertical integration
-Mergers can often create new problems of communication and coordination within a bigger and more disparate firm. It can then lead to diseconomies of scale where the new bigger firm is more inefficient.
-Companies might lose the benefits of specialized expertise when they integrate various stages of the supply chain.
-In some cases, vertical integration may raise competition concerns, especially when a company gains significant control over an entire industry or market.
-With internal control over different stages, companies may become complacent and rely less on external innovation
Adv of Horizontal integration
-Exploit internal economies of scale (leading to lower LRAC) – lower average costs can lead to increased profits
-Cost savings from the rationalization of the business – this often this involves job losses in a bid to increase productivity.
-Create a wider range of products - (diversification) – this creates opportunities for economies of scope.
-Reduces competition by removing one or more key rivals – this increases market share and long-run pricing power.
-Buying a well-known brand can be cheaper in the long run than organically growing a brand and makes entry barriers higher for potential rivals
DisAdv of Horizontal Integration
-Reduced flexibility – the addition of more personnel and processes in the merged business means more legal accountability and extra red tape which can then slow down the rate of business innovation
-Risk of diseconomies of scale (which causes an increase in long run average cost) from the enlarged businesses especially if there are clashes of management style and corporate culture
-Risk of attracting scrutiny from competition authorities who might be worried that a merger might lead to a lessening of competition which could lead to higher prices and a decline in consumer welfare. For example, a merger between Sainsbury & Asda was blocked on competition grounds (2019)
Motivations for business growth
-Profit motive: Businesses grow to generate improved returns for shareholders. Share valuation is influenced by expectations of future revenues & profits
-Cost motive: Economies of scale increase the capacity of the business leading to lower average costs. This can help to raise profit margins.
-Market power motive: Firms may want market dominance giving them extra pricing power. Larger businesses can take advantage of monopsony power
-Risk motive: Diversification across products & markets can reduce investor risk
-Managerial motives: Managers with objectives tied to business growth often aim for rapid expansion
Mergers and takeovers are good for firms and economies- agree and disagree
For:
-Economies of scale
-Increase market share
-Increase sales and profits
-Brand name becomes established
-Reduced risk
Against:
-Deciding HQ location
-Job Cuts
-Business becomes too large/ monopoly
-Diseconmies of scale
Limits to business growth
-Regulatory Benefits
-Finding skilled staff
-Disruptive technologies
-Financial Constraints
-Size of potential markets
-Controlling costs of a growing business
Regulation and compliance costs
-Health and safety: businesses must adhere to regulations, which may involve purchasing safety equipment, conducting inspections, and providing training for employees
-UK’s General Data Protection Regulation (GDPR) has introduced strict data protection rules for businesses.
-Red tape and delayed planning - getting planning permission for new construction or development projects can be a lengthy and complex process
Competition from new technologies
-Many businesses in the UK have faced challenges from disruptive technologies that have fundamentally changed their industries:
1.London’s iconic black cab drivers faced significant challenges from the emergence of ride-hailing platforms like Uber and Lyft.
2.E-commerce has posed challenges to brick-and-mortar retailers
3.Banks have experienced disruption from fintech startups such as Monzo and Revolut offering innovative digital financial services.
4.Traditional media outlets, including newspapers have faced challenges from online platforms and social media
Financial constraints on business growth
-Limited Access to Capital and Debt – including difficulty in securing loans from banks, attracting venture capital, or accessing equity investment. Smaller businesses often face higher interest rates on loans
-Cash-flow issues - poor cash flow management can impede growth. If a business is struggling to collect payments from customers, has extended payment terms with suppliers, or faces seasonality in its sales.
-High debt levels - excessive debt can become a constraint. High interest payments and principal repayments can limit a business’s ability to allocate funds to growth-oriented activities.
Size of market as a constraint on growth
-Businesses that rely on local customers in small towns or rural areas can face market size constraints
-Some businesses offer custom-made products tailored to individual customers’ preferences. Market size for such products might be limited due to the time and resources required to create each unique item
-Regional cultural products - Some cultural products are inherently limited by regional or cultural appeal such as traditional crafts & foods
-Market size might be constrained by high average prices which causes effective demand to be lower – example: unaffordable electric cars
Economies of scope
Occur where it is cheaper to produce a range of products rather than specialize in a handful of products
Diseconomies of scale
Occur when a business grows so large that the costs per unit increase. As output rises, it is not inevitable that unit costs will fall. Sometimes a business can get too big.
Economies of scale
- Economies of scale are cost advantages companies experience when production becomes efficient, as costs can be spread over a larger amount of goods.
- A business’s size is related to whether it can achieve an economy of scale-larger companies will have more cost savings and higher production levels.
- Economies of scale can be both internal and external. Internal economies are caused by factors within a single company while external factors affect the entire industry.
Internal economies of scale
Originate within the company, due to changes in how that company functions or produces goods.
Internal economies of scale happen when a company cuts costs internally, so they’re unique to that particular firm. This may be the result of the sheer size of a company or because of decisions from the firm’s management. There are different kinds of internal economies of scale. These include:
* Technical: large-scale machines or production processes that increase productivity
* Purchasing: discounts on cost due to purchasing in bulk
* Managerial: employing specialists to oversee and improve different parts of the production process
* Risk-Bearing: spreading risks out across multiple investors
* Financial: higher creditworthiness, which increases access to capital and more favourable interest rates
* Marketing: more advertising power spread out across a larger market, as well as a position in the market to negotiate
External Economies of Scale
Based on factors that affect the entire industry, rather than a single company.
External economies of scale, on the other hand, are achieved because of external factors, or factors that affect an entire industry. That means no one company controls costs on its own. These occur when there is a highly-skilled labour pool, subsidies and/or tax reductions, and partnerships and joint ventures-anything that can cut down on costs to many companies in a specific industry.
Economies and Diseconomies of Scale Graph
U shaped with axis x (output) and y (cost and revenue).
In downward of U- economies of scale as output increases and cost decreases. Upward slope is diseconomies of scale.
Demerger
When a large firm is separated into multiple smaller firms.
Reasons for demerging
-Lack of synergies- synergy is when creating a whole company is worth more than each company on its own. If this doesn’t exist, firms are likely to demerge because they will be worth more.
-Growth/Share Price- each part of the firm could grow at different rates. The faster-growing part might be separated. The growing firm can hold a stronger share price if demerged.
-Diseconomies of scale- If the firm is so large that average costs rise with more output, the firm might choose to split into smaller units.
-More focused companies- The firm might be able to grow faster if it focuses on fewer markets rather than lots of different markets/ sectors e.g. Dart group becoming Jet 2.
-Resources- If a firm is experiencing long term cash flow issues, they might sell off a part to raise cash. Selling off part of the firm can raise valuable finance, which could be better invested in a more profitable part of the firm.
Demergers Impact on Workers, Firms and Consumers
Impact on Workers:
-Demerged companies may need separate managers, which could lead to promotions.
-However, demergers aim to increase efficiency, which could result in job losses.
Impact on Firms:
-Focussing on a smaller demerged business may allow the business to be more innovative and efficient.
-However, could lose economies of scale.
Impact on Consumers:
-Consumers may gain from innovative businesses leading to better products.
-However due to firm losing economies of scale, prices might rise.
Business Objectives - Profit Maximisation
Traditionally firms wish to maximise profit. Normal profit (salaries and wages inc in total cost) covers the opportunity cost of remaining in the industry. This is included in the total cost faced by the firm. Profits above this are known as supernormal profits. If firms are in a position to choose ouput and price, they will produce where the difference between TR and TC is the greatest. This can be demonstrated on a TC/TR graph largest profit when largest gap between lines.
Business Objectives- Revenue Maximisation
Firms/Managers may decide to maximise their revenue as they have objectives to increase cashflow. Output will be set at the level where TR is the highest. This may result in them selling higher quantities than if they were profit maximising.
Business Objectives- Sales Maximisation
The objectives may be to maximise the volume of sales in order to meet growth targets. This may result in prices being lowered and output being set at breakeven point where TC=TR ( normal profit is included in the costs)
Business Objectives- Long Run Profit Maximisation
Firms may choose to operate where they are making a loss if they believe in the long run this will gain them market share and higher profits e.g. Ryanair.
Behavioural Theories
-Satisficing- managers will run the firms to meet the minimal requirements of the shareholders. An illustration of the principal-agent problem.
-Borded Rationality - Managers can only work with the knowledge they have and set objectives accordingly .e.g. they may not have been able to predict exchange rate/tax fluctuations.
-Corporate Social Responsibility (CSR) - firms meet objectives of environmental/social obligations.
Motivations for Revenue Maximisation
-Market Penetration and Expansion- In the early stages of a business or when entering a new market, focusing on revenue can help the company gain market share, build brand recognition and establish a customer base.
-Costs- higher output and revenue may enable the business to achieve economies of scale and enhance competitiveness over the long term.
-Attracting Investors and Financing- Businesses with strong revenue growth can be more attractive to investors and lenders.
-Business valuation and exit strategies- Businesses aiming to be acquired might focus on revenue growth to enhance their valuation.
-Business Survival- Cutting prices to increase revenue and improve cash flow can be an important way of surviving in an economic downturn.
Marginal Cost
The change in total cost for a business as a result of a one-unit change in output.
Change in TC / Change in Output (Q)
E.g. of low marginal cost - Online courses, Mass Production
E.g. of high marginal cost - Training staff, housing, aeroplanes, Specialised products such as suit tailors.
Why is Marginal Cost Important
- Businesses aiming to make profits need to have an indication of the marginal cost of supplying extra output. They can make higher profits, providing the marginal cost is less than the marginal revenue.
If the marginal cost of increasing output is low, then a firm might benefit from expanding their production because it will lead to a fall in the average (or unit) cost of supply.
Can Marginal Cost be hard to measure?
-Many firms engaged in mass production do not change their output in single units. They might produce ‘batches’ of extra output by adding more shifts to their factory productions.
-It is probably easier to measure marginal cost for ‘tangible output’ such as an extra barrel of oil or tonne of steel. Harder to accurately calculate the marginal cost of more people using a train service.
“Short Run” in Production
- In economics, short-run production refers to a period of time during which at least one factor of production (usually capital, such as machinery) remains fixed, while others can be varied.
- Variable factors might include labour and intermediate inputs
- This concept is central to understanding the relationship between inputs and outputs in the production process.
- The short run is characterized by the limited ability to adjust certain inputs, which leads to a constrained production (supply) capacity.
Law of Diminishing Returns
- The law of diminishing returns operates in the context of at least one fixed input and one variable input. The fixed input (usually capital) remains constant during the short run, while the variable input (usually labour) can be increased or decreased.
- The law of diminishing returns states that as more units of a variable input are added to a fixed input, after a certain point, the marginal product of the variable input will begin to decrease.
- In other words, the additional output produced by each additional unit of the variable input will start to decrease, ceteris paribus (i.e., with all other factors remaining constant)
Explaining the Law of Diminishing Returns
- Initially, as the farm adds more labour inputs, the total output of wheat increases rapidly.
After a certain point (in this case, after 4 - labour inputs), the total output starts to
increase at a diminishing rate. - Adding the 4th labour input only increases output by 10 bushels
- Adding the sixth labour input only increases output by 2 bushels
- Falling marginal product signifies diminishing returns.
When Diminishing Returns set in, the marginal product of labour starts to fall. When the marginal product of labour declines below existing average product then the average product of labour will fall .
