Theme 3 - Microeconomics Flashcards
Sizes and types of firms
Reasons why some firms tend to remain small and why others
grow:
By growing, a firm will be able to experience economies of scale which helps them
to decrease their costs of production. They will also be able to sell more goods and therefore make more revenue. Together, these will help a firm to make a larger
profit: and many firms are motivated by profit.
● A larger firm will hold a greater share of their market. This will give them the ability to
influence prices and restrict the ability of other firms to enter the market,
helping them to make profits in the long run. Monopoly power often means firms have
monopsony power, and so will be able to reduce their costs by driving down the
prices of their raw materials.
● A larger firm will have more security as they will be able to build up assets and
cash which can be used in financial difficulties. Moreover, they are likely to sell abigger range of goods in more than one local/national market and so they will be
less affected by changes to individual products or places.
The principal agent problem:
In many large firms, there is separation of ownership and control:
In many large firms, there is separation of ownership and control:
● Firms are owned by their shareholders , who play no part in the day to day running
of the business.
● The chief executive and senior managers work for the company and control
day-to-day decision making.
● Shareholders are represented by a Board of Directors, who oversee the way the
business is run. They are able to vote directors onto and off the Board of Directors
at the AGM. However, this often makes little difference and shareholders have more
power through buying and selling shares : if share prices drop significantly, the
board may be encouraged to change their strategy.
The principal-agent problem
This separation causes problems due to the differing aims of the two stakeholders:
The owners will want to maximise the returns on their investment so will want to
short-run profit maximise.
● However, directors and managers are unlikely to want the same thing: as employees,
they will want to maximise their own benefits.
This is the principal-agent problem, where one group, the agent, makes decisions on
behalf of another group, the principal. In theory, the agent should maximise the benefits
for those they are looking after, but in practice, agents are tempted to
maximise their own benefits. For this reason, many firms are not run to
profit-maximise but to profit satisfice; a concept looked at in unit 3.2. The issue could be
overcome by giving managers shares in the business or linking their bonuses to profits, this
will mean that they personally will gain from higher profits.
An extreme example of this problem is the Enron Scandal (2001). The executives used
loopholes to hide billions of dollars in debt from the Board of Directors. The shareholders
filed a lawsuit to the firm and the executives when share prices fell from nearly $100 to less
than $1 in just over a year.
Private sector
refers to that part of the economy that is owned and run by
individuals or groups of individuals, including sole traders and PLCs.
Public sector
The public sector refers to that part of the economy which is owned or controlled by
local or central government. The purpose of these organisations is to provide a
service for UK citizens and profit-making is not their main aim, some may even make
a loss which is funded by the taxpayer.
Profit and not-for-profit organisations:
A profit organisation aims to maximise the financial benefit of its shareholders and
owners. The goal of the organisation is to earn maximum profits.
A not-for-profit organisation has a goal which aims to maximise social welfare. They
can make profits, but they cannot be used for anything apart from this goal and the
operation of the organisation.
Business growth
Organic growth-internal growth
Organic growth is where the firm grows by increasing its output, for example, increased investment or more labour. They may open new stores, increase their range of products etc. Almost all growth of firms is organic.
Advantages and Disadvantages ORGANIC GROWTH
Advantages:
● Integration is expensive, time-consuming and high-risk, with evidence suggesting
that the long-term share price of the company falls following integration. Firms often
pay too much for takeovers and integration is often poorly managed with many key
workers tending to leave after the change.
● The firm can keep control over its business.
Disadvantages:
● Sometimes another firm has a market or an asset which the company would be
unable to gain through organic growth. For example, integration would allow a
European company to expand into the Asian market which it has no expertise in.
● Organic growth may be too slow for directors who wish to maximise their salaries.
● It will be more difficult for firms to get new ideas.
Vertical integration
Vertical integration is the integration of firms in the same industry but at different stages
in the production process . If the merger takes the firm back towards the supplier of a
good, it is backwards integration. Forward integration is when the firm is moving towards
the eventual consumer of a good.
- Tesco’s £3.7bn takeover of Booker in 2018 is an example of vertical integration. It has led to
an increase in sales for Tesco.
Advantages of Forward and backward vertical integration
- There is increased potential for profit as the firm takes the potential profit from a larger part of the chain of production.
● There will be fewer risks as suppliers do not have to worry about buyers not buying their goods and buyers do not have to worry about suppliers not supplying the goods.
● With backward integration, businesses can control the quality of supplies and ensure delivery is reliable. Moreover, they don’t have to worry about being charged high prices for supplies, keeping costs low and allowing lower prices for consumers.
This can increase competitiveness and sales.
● Forward integration secures retail outlets and can restrict access to these outlets for
competitors.
Disadvantages of forward and backward integration
Firms may have no expertise in the industry they took over, for example, a car manufacturing company would have deep knowledge of car manufacturing but little knowledge of selling cars and vice versa.
Horizontal integration
this is where firms in the same industry at the same stage production integrate.
- In 2015, AstraZeneca acquired ZS Pharma for $2.7bn. It gave them access to new compounds and was a long term deal intended to strengthen a specific sector of their business. Other well-known examples are Currys PC Worlds and Arcadia, which own
Topshop, Evans, Dorothy Perkins etc.
Advantages of horizontal integration
This helps to reduce competition as a competitor is taken out and increases
market share, giving firms more power to influence markets.
● Firms will be able to specialise and rationalise, reducing the areas of the
businesses which are duplicated.
● The business can grow in a market where it already has expertise, which is more likely to make the merger successful.
Disadvantages of horizontal integration
The problem is that it will increase risk for the business as if that particular market fails, they have nothing to fall back on and will have invested a lot of money into that area. They are ‘placing all their eggs in one basket’.
Conglomerate integration:
This is where firms in different industries with no obvious connections integrate. They can sometimes be linked by common raw materials/technology/outlets.
adv and disadvantages of Conglomerate integration
It is useful for firms where there may be no room for growth in the present market.
● The range of products reduces the risk for firms and if a whole industry fails, they will still survive due to the other parts of the business.
● It will make it easier for each individual part of the business to expand than if they were on their own as finance can be easily obtained and managers can be transferred from company to company within the firm.
Disadvantages:
● The problem with this is that firms are going into markets in which they have no expertise. It can often be damaging for the business.
Constraints of business growth:
Size of the market: A market is limited to a certain size and so not all businesses are able to mass produce because their goods would not be bought by consumers. This can happen no matter how big the market is, and there will always be limits on growth. In particular, niche markets (specific products that few people want) and markets for luxury items or restricted prestige markets make it difficult for businesses to grow.
● Access to finance: Firms use two main ways to finance growth: retained profits and loans. If firms do not make enough profit or have to give out too much to shareholders, they will not be able to use retained profits to grow. Banks may be unwilling to lend firms money, particularly smaller businesses that they see as high risk. As a result, firms will be unable to grow as they can’t finance it.
● Owner objectives: Some owners may not want their business to grow any further as they are happy with their current profits and do not want the extra risk or work that comes with growth.
● Regulation: In some markets, the government may introduce regulation which prevents businesses from growing. For example, the UK government regulates the
number of pharmacies in a local area and an existing pharmacy can only expand by buying another company. Competition law, which prevents monopolies, can restrict growth as any merger which creates a company with more than a 25% market share
can be forbidden from taking place.
Demergers
A demerger is a business strategy in which a single business is broken into two or more components, either to operate on their own, to be sold or to be dissolved.
Reasons for demergers
Lack of synergies: This is when the different parts of the company have no real impact on each other and fail to make each other more efficient. Lack of synergy means managers are splitting their time between areas which are so different it could
lead to diseconomies of scale; firms may split in order to avoid these diseconomies.
● Value of the company/share price: Some companies demerge because the value of the separate parts of the company is worth more than the company combined. This is because some parts of the business are operating well and have potential to
grow but the overall value is brought down because of the lack of success or lack of potential for growth of other parts of the business. Financial markets talk about ‘creating value’ by splitting up companies like this.
● Focussed companies: Some people believe if the company and the management are more focussed on individual markets they become more efficient and successful, and make higher profits. Management has limited time and skills and they are
unable to spend the required time to make all areas of a huge diverse business successful. By focusing on one area, managers can improve their skills and knowledge and become more successful.
● They may also want to avoid attention from the competition authorities.
Impacts of demergers
Workers: Workers could gain or lose through a demerger. Separate firms may need their own managers and leaders so people can get a promotion. However, the goal of making the firm more efficient may result in job losses.
● Businesses: Concentrating on a smaller core business may enable it to be more efficient and concentration may lead to more innovation and surviving higher competition. However, the smaller size of the business could lead to a loss of economies of scale and reduce efficiency.
● Consumers: Again, consumers could gain or lose. They may gain from innovation and efficiency, leading to better products and cheaper prices . However, demerged firms may be less efficient through loss of economies of scale or raised prices/reduced quality or range of goods as they become motivated by profits.
Profit maximisation:
A firm’s profit is the difference between its total revenue (TR) and total costs (TC). A firm profit maximises when they are operating at the price and output which derives the greatest
profit. Profit maximisation occurs where marginal cost (MC) = marginal revenue (MR). In other words, each extra unit produced gives no extra loss or no extra revenue.
- Profits increase when MR > MC. Profits decrease when MC > MR
To short-run maximise, firms produce where MC=MR. If they produce less than this, then producing more will increase profit since MR would be higher than MC so they’re
making more in revenue than it costs to produce the good and so producing more would increase profit. If they produce more than this, they would be making a loss on the goods produced above the profit maximising point and so they should decrease production. The diagram shows that the firm will produce at P1Q1: the output is determined by where MC=MR and the price at this output is determined by the AR curve. Cost and revenue diagrams are looked at in more detail in the following units.
Some firms choose to profit maximise because:
It provides greater wages and dividends for entrepreneurs
- Retained profits are a cheap source of finance, which saves paying high interest rates on loans
- In the short run, the interests of the owners or shareholders are most important, since they aim to maximise their gain from the company.
- Some firms might profit maximise in the long run since consumers do not like rapid price changes in the short run, so this will provide a stable price and output
Revenue maximisation:
This occurs when MR = 0. In other words, each extra unit sold generates no extra revenue
Amazon follow an objective of revenue maximisation, with revenue nearing £120bn in 2015 but profit staying relatively stable. Their aim is to dominate the market.
To revenue maximise, firms would produce where MR=0, since if marginal revenue is above 0 producing more would increase revenue. This means they produce Q2P2, whilst profit maximisation would produce at Q1P1.
.Prices would be lower than when they are profit maximising since they are producing more.
Sales maximisation:
This is when the firm aims to sell as much of their goods and services as possible without making a loss. Not-for-profit organisations might work at this output and price. On a
diagram this is where average costs (AC) = average revenue (AR).
In order to sales maximise, the firm will want to get the highest level of sales possible without making a loss. They will want to ensure sufficient returns to keep the owners happy, so will aim for normal profits. As a result, they produce where AC=AR at P2Q2. Prices are lower
and output is higher than they would be under profit maximisation.
The problem with both sales maximisation and revenue maximisation is that it necessitates a fall in price , which other firms may copy and so there may be no or little increase in revenue
or sales: this is important in oligopoly. They also bring lower profits.
Satisficing:
. A firm is profit satisficing when it is earning just enough profits to keep its shareholders happy.
- Shareholders want profits since they earn dividends from them. Managers might not aim for high profits, because their personal reward from them is small compared to shareholders. Therefore, managers might choose to earn enough profits to keep shareholders happy, whist still meeting their other objectives.
- This occurs where there is a divorce of ownership and control.
- The state of the economy can affect a firm’s objectives. For example, a firm may be less likely to adopt a profit maximising objective if the economy is in a recession.
Total revenue:
Total revenue is calculated by price x quantity sold. It is the revenue received
from the sale of a given level of output.
Marginal revenue:
- This is the extra revenue a firm earns from the sale of one extra unit. When marginal revenue is 0, total revenue is maximised.
- The point where MR = 0 on the revenue diagram is directly below the midpoint of the AR curve. This is in the middle of the demand curve and it is the point where PED = 1.
- If prices rise or fall around this point, TR would fall. -
Average revenue:
- Average revenue (AR) is the average receipt per unit. This is calculated by TR / quantity
sold. In other words, this is the price each unit is sold for.
The AR curve is the firm’s demand curve. This is because the average revenue curve is the price of the good.
In markets where firms are price takers, the AR curve is horizontal. This shows the perfectly elastic demand for their goods.
In markets where firms are price makers, the AR curve is downward sloping
PED and its relationship to revenue concepts:
In markets where firms are price takers, the AR curve is horizontal. This is because the price received for the good is constant. This shows the perfectly elastic demand for their goods. AR= the demand curve, because AR is the price of the good, and the demand curve shows the relationship between price and quantity.
Average revenue = marginal revenue.
If demand is elastic and price increases, the quantity demanded will fall. The effect on total revenue depends on how elastic the demand is. For example, if price rises by 10% and demand decreases by 20%, then the elasticity of demand is +2. This means demand is very elastic and total revenue decreases. If prices rise by 10% and demand decreases by 1%, the price elasticity of demand is +0.1.
Demand is relatively inelastic, and revenue increases.
Usually, the AR curve is downward sloping, because the price per unit is reduced as extra units are sold.
The price elasticity of demand changes as you move down a downward sloping demand
curve.
Total cost
This is how much it costs to produce a given level of output. An increase in output results in an increase in total costs. Total costs = total variable costs + total fixed costs
Total fixed cost:
In the short run, at least one factor of production cannot change. This means there are some fixed costs. Fixed costs do not vary with output. For example, rents, advertising and capital goods are fixed costs. They are indirect costs.
Total variable cost:
In the long run, all factor inputs can change. This means all costs are variable. For example, the production process might move to a new factory or premises, which is not possible in the short run. Variable costs change with output. They are direct costs. For example, the cost
of raw materials increases as output increases.
Average costs:
Average (total) costs (ATC) = total costs / quantity produced. ATC = AVC + AFC.
Average fixed costs (AFC) = total fixed costs/quantity.
Average variable costs (AVC) = total variable costs/quantity.
Marginal cost:
This is how much it costs to produce one extra unit of output. It is calculated by ∆TC÷∆Q.
When a firm’s total variable costs increase, both its marginal cost curve and average cost curve shift upwards. When a firm’s total fixed costs increase, only its average cost curve shifts upwards.
Short-run cost curves
The short run is the length of time at least one factor of production is fixed and cannot be changed; this varies massively with different types of production. The long run is when all factors of production become variable
Diminishing marginal productivity
if a factor of production is fixed, this will affect the business if it decides to expand. More workers can be added this will lead to an increase in production as machinery is used more efficiently. However, it will take a long time for the factory to expand and adding more labour will mean that they will have less and less impact on the amount produced as they get in the way and have no machines to use. This is called the law of Diminishing returns or diminishing marginal productivity.
diminishing marginal productivity means that if a variable factor is increased when another factor is fixed, there will come a point when each extra unit of the variable factor will produce less extra output than the previous unit.
Marginal output will decrease as more inputs are added in the short run. This will mean that the marginal cost of production will rise
Average fixed cost curve AFC
Starts high because the whole fixed costs are being divided by a small output. As output is increased, AFC falls as the same amount is divided by a larger number.
Average total cost curve ATC
is U-shaped due to the law of diminishing marginal productivity. Costs initially fall as machinery is used more efficiently but as production continues to expand, efficiency falls as machinery is overused
Average variable cost curve AVC
U-shaped, but it gets closer to ATC as output increases since AFC gets smaller
Marginal Cost MC
U-shaped due to the law of diminishing marginal productivity. It will initially fall as the machines are used more efficiently but will rise as production continues to rise.
Curves
The marginal cost line will always cut AC line at the lowest point on the AC curve: if MC is below AC, then AC will continue to fall since producing one more costs less than the average so the average falls; but if MC is above AC, then AC will rise. Marginal costs can rise whilst AC is still falling, as long as MC is still below AC.
Each firm will have a different total cost curve. If average costs are constant, the line would be a straight diagonal line beginning at the origin. When output is 0, fixed costs are equal to total costs since there are no variable costs.
The relationship between short-run and long run cost curves
SRAC curves are U-shaped because of the law of diminishing returns whilst LRAC curves are U-shaped because of economics and diseconomies of scale.
LRAC is an envelope for all the associated SRAC curves because the LRAC is either equal to or below the relevant SRAC. In the short run, there will be a rise in SRAC due to the law of diminishing returns as some factors of production are fixed. In the long run, all factors become variable and so the SRAC curve can be shifted. The new SRAC curve will be lower since the firm can enjoy the economics of scale.
- Up until output Q1, the firm experiences economics of scale and so sees falling LRAC.
From output Q1 until Q2, the firm has constant returns to scale where their LRAC are constant. Any output above Q2 means the firm experiences diseconomies of scale and their LRAC rises.
Shifts and movement of the LRAC curve
the long-run average cost curve is a boundary representing the minimum level of average costs attainable at any given level of output. Points below the LRAC are unattainable and producing above the LRAC is inefficient.
Movement along the LRAC is due to a change in output which changes the average cost of production due to internal economics/diseconomies of scale. A shift can occur due to external economics/diseconomies, taxes or tech, which affects the cost of production for a given level of output.
Synoptic point
Macroeconomic changes can have implications on a firms cost curves. For eg exchange rates or tax changes. A firm’s costs also have macroeconomic effects. High costs will reduce the competitiveness of
the country, and this will reduce exports and lead to a current account deficit. It will also reduce LRAS.
Internal economies of scale:
These occur when a firm becomes larger. Average costs of production fall as output
increases.
Examples of internal economies of scale can be remembered with the mnemonic
Really Fun Mums Try Making Pies
Risk-bearing
When a firm becomes larger, they can expand their production range.
Therefore, they can spread the cost of uncertainty. If one part is not successful, they have other parts to fall back on.
Financial
Banks are willing to lend loans more cheaply to larger firms, because they
are deemed less risky. Therefore, larger firms can take advantage of cheaper credit.
Managerial:
Larger firms are more able to specialise and divide their labour. They
can employ specialist managers and supervisors, which lowers average costs.
Technological
Larger firms can afford to invest in more advanced and productive
machinery and capital, which will lower their average costs.
