Topic 5 - Business Behaviour Flashcards
What is divorce of ownership from control ?
As firms grow, they may sell shares to finance their expansion.
Shareholders do not run the company, managers do.
So, there is a divorce of ownership and control.
What is the principle agent problem ?
Due to divorce of ownership from control
The interests of the manager may not be in the interest of the shareholder but shareholders are not able to very easily monitor the behaviour of managers.
The manager may benefit more from revenue maximisation than profit maximisation, and so the manager may not act in the shareholders best interest.
How can shareholders regain control from managers/realign their values ?
This can be done by holding them accountable for the firms performance, adding pressure for them to perform in the shareholder’s interest.
Managers could also have their pay linked to the share price over a number of years, for example.
This realigns the goals of managers and shareholders
What are the reasons some firms grow and other firms stay small ?
Owner objectives
Access to capital
Type of firm
Size of market
What are reasons owner’s objectives keep a firm from growing ?
Some business owners or founders may decide that they don’t want to grow.
Growing and hiring more employees increases the amount of legal, accounting and bureaucratic burden for a firm.
Owners may be risk-averse and just want to run a ‘lifestyle business’ that can fund their own desired income. Satisficing
For example, a software developer setting up a company to sell his services may not want to hire other developers and grow, preferring to focus on funding his own income.
How does access to capital stops a firm from growing ?
If a business cannot access capital, then it is unable to spend anything other than profits to grow. When companies are small, often they don’t make huge profits because they have to cover both their fixed and variable costs, but don’t have many customers to spread their fixed costs over.
After the 2008 financial crisis, many businesses reported that banks would not lend to them.
CB Insights research finds that 29% of failed startups failed because they ran out of cash.
If a company cannot issue equity or borrow from banks, then it has bad access to capital.
How can the type of firm stop a firm from growing ?
Not for profit firms may only hope to improve one social issue in one area - e.g. homelessness in Leeds. They may have no incentive to grow, even if they could.
Firms or departments in the public sector may have no incentive to grow. The UK Department for Education has no funds allocated and no desire to expand internationally.
How can the size of market stop a firm from growing ?
Sometimes the size of a company’s market is not large enough for a firm to grow anymore. If a company sells Chilli-flavoured ice cream, there may not be enough demand outside of very niche ice cream shops. This can limit growth because the firm is in a ‘niche market’.
Research by CB Insights found that 42% of startups failed because the market didn’t need their product and 9% failed because of a failed geographic expansion.
How can a business grow ?
Organically - Businesses can grow organically by expanding their own operations.(slower,less risky)
external expansion - acquiring other businesses
What are ways a business can grow organically ?
Opening new stores
Launching new products
Increasing product capacity
How is opening a new store organic growth ?
Opening a new store is a common way for a company to expand as it allows them to be closer to customers in another location. It can be low risk if the business model is already proven to work.
Aldi and Byron burger shop are examples of this. They opened up lots of stores in different towns, all using a similar business model and operations.
However, internal expansion can need a lot of investment and can be costly.
How is launching new products organic growth ?
Launching new products can help businesses to expand their customer base as well as potentially selling more products to people who are already customers.
For example, Virgin Records then launched the Virgin Trains, Virgin Atlantic (airline) and Virgin Active (gyms) businesses.
This can be risky due to the large investment required and the fact the business owner may not be as knowledgeable in other product markets
How is increasing production capacity an example of organic growth ?
Investing in new capital and technology can allow a business to produce more goods.
If for example, a firm’s products are consistently selling out and they are unable to produce more, then the production capacity is restricting their expansion.
What are the types of external growth ?
Horizontal integration
Conglomerate integration
Backwards vertical integration
Forwards vertical integration
What is horizontal integration ?
Horizontal integration would involve two competitors operating in the same business area having a merger/acquisition.
Asda and Sainsbury’s proposed merger is an example of horizontal integration.
What is conglomerate integration?
Conglomerate integration is a merger/acquisition between two completely unrelated businesses.
Apple purchasing Tesco would seem to be an example of this.
However, Amazon buying Whole Foods may not be an example of conglomerate integration, rather backward vertical integration by Amazon, as Amazon already distributed some food to consumers.
What is backwards vertical integration ?
Backward vertical integration involves acquiring companies that are further up the supply chain than the acquirer.
Apple purchasing Vrvana, who make specialist digital screens for VR is an example of backward vertical integration.
What’s forward vertical integration ?
Forward vertical integration involves a business moving closer towards the customer. This would involve buying a business involved in the distribution directly to customers.
Samsung buying a chain of retail stores like Dixons would be an example of forward vertical integration.
What’s a merger ?
when 2 firms combine to make 1 large company (e.g. Disney and Pixar in 2006).
What are takeovers ?
1 firm buys a controlling stake (50%+) of another firm (e.g. Virgin Active and Esporta in 2011)
What are the advantages of external expansion?
Reduce competition
Rapid expansion
Diversify (spread) risk
How is reduction of competition an advantage of external expansion ?
A firm can merge with or take over a competitor.
This can reduce the amount of competition that a business faces. It can also increase market share and let the company benefit from economies of scale.
For example, in 2004, the Morrisons supermarket company took over Safeway supermarkets. This increased the number of Morrisons stores to over 500 from 120. Morrisons’ market share rose from 6.4% to almost 15%. This was another example of horizontal integration
How is rapid expansion a benefit of external expansion ?
The key benefit of external expansion is the speed with which firms can expand.
For example, in 2014 Facebook bought WhatsApp for $19 billion. This is a large amount of money but it instantly gave Facebook 700 million customers. This was an example of vertical integration.
How is diversifying (spreading risk) an advantage of external expansion ?
A firm can merge or take over a firm in a different industry. This makes the company less reliant on its existing products/services and can diversify (or spread) a company’s risk.
For example, in 2011, Microsoft (an operating system company) bought Skype (a video calling company). This was either a conglomerate integration or a horizontal integration.
What are the disadvantages of integration ?
Demotivated employees
Tension and job loss
Complicated
Why may employees become demotivated after integration ?
Employees may be demotivated due to different management style and culture.
When Virgin Active took over Esporta Health Clubs, personal trainers and other gym staff became frustrated with new working practices. Staff turnover increased significantly after this takeover.
Daimler (the company that makes Mercedes cars) merged with Chrysler in the late 1990s. The company had very different cultures and in 2007, Chrysler was sold by Daimler to an investment company.
Why may tension and job loss occur when integration occurs ?
Mergers and takeovers often lead to attempts to cut costs.
Attempts to cut costs often lead many people to lose their jobs and this can create tension in a workforce.
This happened when Morrisons took over Safeways supermarkets in the UK in 2004.
How does complication happen when integration occurs ?
The costs of a merger/takeover can outweigh the benefits.
For example, the two businesses’ operations will have to merge.
If 2 businesses employ 5,000 people in 30 countries, combining this operations would not be easy or straightforward. This can lead to diseconomies of scale.
What’s a demerger ?
the reversal of a merger between two firms or the reversal of a takeover. One large firm is broken into two or more smaller firms
What are reasons for demergers ?
Failed merger
Underperforming business unit
Antitrust
Investment or debt
Diseconomies of scale
Why is a failed merger a reason for a demerger ?
If firms merged hoping to cross-sell extra products to customers and this failed then they may demerge.
If firms merged to try to cut costs by sharing some costs, but this failed, then they may demerge.
Why is underperforming business unit a reason for a demerger ?
If only one part of the business area is underperforming then it may make sense to demerge that part of the business so that management can focus more on the more successful business areas or units.
Equity markets may increase the ‘multiple’ that investors will pay for a business if it only contains 1 successful business instead of 1 successful business and 3 underperforming businesses. Therefore a demerger could create shareholder value.
Philips sold off their Philips Lighting business via an IPO to focus on higher margin businesses.
How is antitrust a reason for a demerger ?
Like how governments block some takeovers, a firm may demerge because of government intervention.
If a government views a monopoly market structure as a market failure, then the government may force the firm to be broken up.
Standard Oil was split up by the US Supreme Court into multiple smaller oil companies in 1911.
How is investment or debt a reason for a demerger?
A firm may sell off one of its divisions to pay off business debts or to undertake a major investment programme.
Hewlett Packard separated their software and hardware businesses in 2017.
How is diseconomies of scale a reason for a demerger ?
If the firm is too large and is experiencing diseconomies of scale then a firm may decide that a demerger is better for shareholders
What is the impact of a demerger on business ?
A business is likely to have a better focus after a demerger.
The total equity value of the business units may rise after a de-merger. If the businesses were unrelated, then a ‘conglomerate discount’ may vanish.
If a business was suffering from diseconomies of scale, then a demerger may increase efficiency and lower average cost. However, if the business was operating at the minimum efficient scale, then a lower output may increase average cost.
Selling a loss-making business is difficult. People are more likely to want to buy a successful business. ‘Realising a loss’ on a past acquisition and accepting it was a bad choice may harm management’s power in the business.
What is the impact of a demerger on workers ?
Some workers may be forced to work for a new legal entity or employer. There may be cultural clashes or a fall in morale.
If the demerger happens to fund investment, then some of this investment may be in machinery or automation tools that reduce the need for labour.
Operating in a smaller firm may be good for workers. Dunbar’s number finds that people can operate in groups of up to 150 whilst maintaining strong social relations with all of the other members of the group.
What is the impact of a demerger on customers ?
If demerging stops a firm suffering from diseconomies of scale, efficiency could rise, costs could fall and prices could also fall, increasing the level of consumer surplus.
But if the firm loses economies of scale, costs could rise and prices could rise. This is likely to reduce consumer surplus and consumer welfare.
But having more firms in an industry may increase choice and competition, leading to higher quality products/services and lower prices.
If demerging stops a firm suffering from diseconomies of scale, what could happen to the consumer surplus?
Increases
What’s the traditional theory on firms main objectives ?
Profit maximisation
What is the point of profit maximisation ?
Firms maximise profit when the marginal revenue (MR) is equal to the marginal cost (MC).
Any extra units produced from here will have a negative impact on profit.
This is because of diminishing returns. So marginal cost will be higher than marginal revenue past this point of MC=MR.
What will some firms do with profit ?
Pay dividends to shareholders.
Save the money for future use.
Invest towards future growth, e.g. in R&D.
To make profit, what does a firm have to achieve ?
To make profit, firms may have to achieve a number of other objectives first.
E.g to gain long run profit it might be more important to gain revenue and market share in the short term, even if profit must be sacrificed.
Amazon has made very little profit in the last 10 years and seems to have aimed to maximise market share in the short run
With use of an example, explain why firms might not be able to immediately maximise profit?
To make profit, firms may have to achieve a number of other objectives first.
E.g to gain long run profit, it might be more important to gain revenue and market share in the short term so that economies of scale and price-setting power can be first achieved, even if profit must be sacrificed.
Amazon has made very little profit in the last 10 years and seems to have aimed to maximise market share in the short run. A challenge for Amazon would be how to increase their profit margin (how much is charged to the customer over and above costs) without making itself vulnerable to competition.
What are some firms objectives other then profit maximisation?
Market share (sales maximisation)
Corporate social responsibility
Satisificing
Not for profit
Revenue maximisation
What is market share as a firms objective ?
Firms may try to maximise market share (without making a loss), also known as sales maximisation.
To do this, a firm would produce where average revenue is equal to average cost.
A company such as Tesco may focus on this; it would allow them to achieve economies of scale and greater price-setting power in the long-run.
This could be beneficial to managers due to the prestige, and the perks they may receive from managing a large firm.
What is corporate social responsibility as a firms objective ?
This involves firms acting in a sustainable way whilst trying to make supernormal profit.
E.g a firm might aim to produce its goods whilst keeping carbon emissions low.
This can be beneficial for society.
