Unit 3 Flashcards
Why do some Small Businesses tend to Remain Small?
Lack of finance for expansion
Fear of expansion
Avoiding diseconomies of scale- in a quickly grown firm there could be poor organisation, x-inefficiency, or having to higher wages
Providing niche products to maximise profit- due to more inelastic demand
Providing a more personal service
Acting as local monopolies
What are the Motives for the Growth of Firms?
To generate more profits
To benefit from economies of scale, meaning lower costs of production
To get more market power
Firms may want to diversify; so if sales drop in 1 market they can still generate sales
Senior managers may wish to grow, to control a larger business
What is the Principal-Agent Problem?
When the agent makes decisions for the principal, but the agent is inclined to act on their own interests, rather than those of the principle.
e.g. Shareholders and managers have different objectives which may conflict.
Can be linked to the theory of asymmetric information
What are Profit Organisations?
A profit organisation aims to maximise the financial benefit of its shareholders and owners.
The goal of the organisation is to earn Maximise Profits.
What are Not-For-Profit Organisations?
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.
What are Public Sector Organisations?
When the government has control of an industry.
There could be natural monopolies in the public sector- where only 1 firm may provide something, because it is insufficient to have multiple sets
Some public sectors yield strong positive externalities (e.g. public transport and education)
What are the Incentives of Public Sector Organisations?
Public sector industries have different objectives to private sector industries, which are mainly profit driven.
Social welfare may be a priority of a public sector industry. It could also lead to a fairer distribution of resources
What are Private Sector Organisations?
When a firm is left to the free market and private individuals
Benefits:
1) 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
2) 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.
What are the Incentives of Private Sector Organisations?
Free market economists will argue the private sector gives firms incentives to operate efficiently, increasing economic welfare.
What is Limited Liability?
Investors (shareholders) and owners can only lose their investment in the business if it fails
They cannot be forced to sell their personal assets to pay off the business debts
What are Shares, and Who are Shareholders?
Shares: A small part of the business
Shareholders: Those who own shares
Who are Owners and Directors of a business?
Owners own the business to directors
Directors run the business. They give shares to the shareholders.
Why do PLC’s and Ltd’s like giving out shares?
Giving out shares to others is cheaper than asking the bank for money (The bank requires Interest)
What are Dividends?
When the shareholders get money for their shares.
If a business expands, the shares get more worth; the shareholders can sell it on for more money
What is Internal/Organic Growth?
When firms grow by expanding their production, output and sales from within the resources of the business.
E.g. research + development, investment in technology, production capacity
What are the advantages of internal growth?
Easier for the owner to manage and control the direction the business goes.
Relatively low risk
Firms grow by building on their own strengths, and using their own funds; which builds up less debt, making it more sustainable.
What are the Disadvantages of Internal Growth?
Growth can be very slow
Market share could fall if other firms grow quicker
No gains from integrating with another business
What is External/ Inorganic Growth?
When firms grow through merging with / acquiring / taking over another firm.
What are the Advantages of External Growth?
Quick to expand, as capacity already exists
Market share is instantly boosted, by the brand name + sales of the other firm
Share of expertise with other successful firms
What are the Disadvantages of External Growth?
Costly to purchase successful firms
Loans taken out to pay for the merger will have interest; opp cost
Problems with managing and controlling a much larger business
What is meant by a merger?
When the directors + shareholders of two firms agree to come together under one board of directors
What is meant by a takeover?
When one firm buys a majority of shares in another, and therefore has full management control.
What is backward vertical integration?
A firm higher up in the production process joins with a firm lower down in the production process.
What is forward vertical integration?
A firm lower down in the production process joins with a firm higher up in the production process.
What is horizontal integration?
Two competitors at the same stage in the production process join together
What is conglomerate integration?
A firm joins with another firm in a completely unrelated business.
What are the Advantages + Disadvantages of backwards vertical integration?
+: Offers reliable and better access to raw materials, so therefore greater control of supply, resulting in reducing costs and improving quality
-: Different cultures in businesses, and potentially diseconomies of scale
What are the Advantages + Disadvantages of forwards vertical integration?
+: Offers reliable and better access to raw materials, so therefore greater control of supply, resulting in reducing costs and improving quality
-: Different cultures in businesses, and potentially diseconomies of scale
What are the Advantages + Disadvantages of horizontal integration?
+ Reduces competition, as there’s one business instead of two
+ Substantial increases in market share
+ Benefits from economies of scale
- Different cultures in businesses, and potentially diseconomies of scale
What are the Advantages + Disadvantages of conglomerate integration?
+ Reduces risk by operating in different markets
+ Benefits from knowledge from the other market
- Requirement of different skills, and cultural differences
What are the Motives for the Growth of Firms?
To generate more profits
To benefit from economies of scale, meaning lower costs of production
To get more market power
Firms may want to diversify; so if sales drop in 1 market they can still generate sales
Senior managers may wish to grow, to control a larger business
What are the constraints on business growth?
- Size of the market
Small market- firms only access a limited consumer market, and so there’s limited opportunities for innovation and expansion - Access to finance
Smaller/ Newer firms are seen as more risky, and so get less loans. With insufficient credit, firms can’t invest + grow, nor innovate - Owner objectives
Owners’ objectives may be different- e.g. Maximising social welfare, maximising profits, environmental objectives, personal gain (reputation) - Regulation
Red tape can limit the quantity of output a firm produces. They also impose taxes (corporation tax, environmental laws + taxes)
What is Divorce of Ownership and Control?
Conflict between aims of owners and directors.
What is the Principle-Agent Problem?
Divorce of ownership creates the principle-agent problem.
The principle is the shareholder, and the agent in the manager and their divergent aims.
Shareholders own LTC/PLC, and wish to maximise profits to maximise their dividends. Managers may have different motives, such as wanting to increase sales at the expense of profit.
What is a Demerger?
When a company sells off some section of the business, and this forms a completely separate company
A demerger is usually carried out by distributing shares in the new business to the existing shareholders.
What are the reasons for demerging?
Lack of Synergies: A synergy is when creating a whole company is worth more than each company on its own. Without this, firms are likely to demerge because they will be worth more.
Growth of businesses at different rates: The faster growing part might be separated
Diseconomies of Scale: If the firm is so large that DoS start to occur, the firm may choose to split
Focused Companies: Firms may grow faster if they focus on a few markets, rather than several
Lack of resources: If firms can no longer invest the business due to a lack of a resources, they might sell off a part
Selling off parts of the firm can raise finance
What is the Impact of demergers on Businesses?
Firms can dispose of underperforming or loss-making parts of firm
More focus on their core activities
Firms can eliminate economies of scale
What is the Impact of demergers on Workers?
Workers’ roles may be shifted between the demerged firm and parent firm
There could be job cuts
Workers might become confused
Increased job security if loss-making parts of the firm are demerged
What is the Impact of demergers on Consumers?
The removal of diseconomies of scale means lower prices
If two firms in the same industry demerge, there is more choice for consumers
What is Revenue?
The income gained from the sales of goods + services, capital, etc. before any costs are deducted.
What is Total Revenue?
Price x Quantity Sold
When price is constant, TR is upwards sloping.
What is Average Revenue?
AR is the price each unit is sold for
TR / Quantity
What is the Relationship between PED to revenue concepts?
Price Takers: when demand is elastic, increasing price will reduce total revenue, and decreasing price will increase total revenue (AR = the demand curve)
Price Makers: when demand is inelastic, increasing price will increase total revenue, and decreasing price will decrease total revenue
What is Marginal Revenue?
The extra revenue gained from the sale of of one extra unit
Change in Revenue / Change in Quantity
What does Revenue look like for a Price Maker and Price Taker?
Price Taker:
Horizontal AR=MR=P=D curve
Upwards sloping TR curve
Price Maker:
Downwards sloping AR curve
Downwards sloping MR curve, crossing 0 at half the quantity of AR
Downwards parabola TR curve, reaching its highest when MR=0
What is Cost?
An expense which a business has to pay.
What is Fixed Cost?
Cost which doesn’t change, regardless to how much is produced.
What are some examples of fixed cost?
Rent, Salaries, Machines, Stationery, Advertising
What is variable cost?
Cost which varies with the level of output
What are some Examples of variable cost?
Utility Bills, Wages, Raw Materials, Packaging, Transportation
How are the factors of production like Over Time?
Short Run: At least one of the factors is in fixed supply
Long Run: Output can be changed- there are no fixed factors
Very Long Run: Technology changes
What is the law of Diminishing Marginal Returns?
Adding more units of a variable input to a fixed input increases product and reduces cost at first.
After a certain amount of input, the marginal increase in output becomes constant.
Eventually, an increase in input will lead to a fall in output/ increase in cost.
What is Average Cost, and how are the types of AC calculated?
The cost per unit of output.
ATC = TC / Q AVC = TVC / Q AFC = TFC / Q
Why does MC cut AC at its lowest point?
When MC < AC, AC falls.
When MC > AC, AC rises.
When MC = AC, AC doesn’t change.
At first, MC < AC, and thus AC falls until they meet. After that, MC > AC, and so AC rises.
What is Marginal Cost?
The additional cost of an additional unit of output is produced.
What does AC and MC look like on a diagram?
MC is a J-curve, and AC is a normal curve.
MC cuts AC at its lowest point.
Why is the MC curve a J-curve?
( i don’t think you have to learn this)
The MC curve is a reflection of the MP curve (via the x axis)
MP increases until DMR comes in. When this happens, each worker is less productive for most of the time, and so the MP falls, and thus MC rises.
What is the Minimum Efficient Scale?
The lowest point on the LRAC curve.
The most efficient level the curve stops falling, it tells us the minimum output required to fully exploit economies of scale.
What is an Evaluation point regarding Diseconomies of scale?
Depends on the Output:
If they’re performing before the minimum efficient scale, they’ll not reach diseconomies of scale
If they’re after the minimum efficient scale, they may be able to stay at that low cost for a while before the cost coming back up
Also: If fixed costs are too high, it will take them forever to get to the minimum efficient scale; yet alone diseconomies of scale
What does the LRAC curve look like, and why?
In the short run, firms want to lower their cost and avoid DMR, and will do this by expanding their capital. This shifts the SRAC curve to the right. Firms keep on doing this, to not be constrained to the amount of capital they have, and to avoid DMR
The LRAC curve enveloped the SRAC curves, where it is always equal to or lower than the SRAC curve.
SRAC falls at first, then rises due to DMR
LRAC falls at first, then rises due to economies of scale.
How is Marginal Cost Calculated?
Change in Cost / Change in Quantity
How is Total Cost Calculated?
TVC + TFC
TVC = VC x Quantity
What is meant by Economies of Scale?
When there’s a fall in the long run average cost of production as output rises.
What are Internal economies of scale?
This occurs within the firm as it expands production
What are the Types of Internal economies of scale?
Purchasing: Firms can get bulk-buying discounts
Risk-bearing: Firms can spread their risk by expanding into new markets
Marketing: Firms can divide their marketing budgets across larger outputs (e.g. dubbed adverts)
Financial: Banks are willing to give out cheaper loans to firms
Technical: Larger firms use smaller scale machinery + factories, which leads to lower costs of production per unit
Managerial: Firms can specialise, and divide their labour
What are External economies of scale?
These are achieves as the industry that the firm is operating in grows
What are the Types of External economies of scale?
Labour: Often a pool of skilled labour will develop in areas in which similar firms operate (e.g. Sillicone Valley)
Ancillary Services: Often support industries (e.g. suppliers) will develop in areas in which similar firms operate. The growth of tourism and travel agents has led to the growth in travel insurance.
Good Reputation: If a country or area builds up a good reputation for producing a good quality product, all the firms in the industry benefit from this.
Improved Infrastructure: The growth of an industry can encourage the government or the private sector to improve infrastructure that services the industry.
(e.g. growth of tourism in the UK has led to the expansion of UK airports
What are Diseconomies of Scale?
They occur when a business grows so large, the costs per unit increase.
What are some Causes of diseconomies of scale?
Diseconomies of scale occur for several reasons, but all as a result of the difficulties of managing a larger workforce:
Poor communication
Lack of motivation
Loss of direction and co-ordination
What does the economies/diseconomies of scale diagram look like?
It looks like a negative parabola
The left side is economies of scale, and the right side is diseconomies of scale.
What is the Minimum Efficient Scale?
The lowest point of the LRAC curve
This is where the optimum level of output is, since costs are lower and the economies of scale of production have been fully utilised
What are Network Economies of Scale?
These are gained from the expansion of ecommerce*.
Large online shops (eBay, Amazon, etc) can add extra goods and customers at a very low cost, but the revenue gained from this will be significantly larger
- commercial transactions conducted electronically on the internet
What is the Condition for Profit Maximisation?
Occurs when MC = MR
This is so that each extra unit produced gives no extra loss or extra revenue
What is Profit?
The difference between Total Revenue and Total Cost
It is the reward that entrepreneurs yield when they take risks
What is a Loss, Normal Profit and Supernormal Profit?
Normal Profit:
The minimum required to keep entrepreneurs supplying their enterprise.
It’s when TR = TC
It is considered to be a cost, and so included in the costs of production
Supernormal Profit:
The profit above normal profit
TR > TC
Loss:
When firms fail to cover their total costs
What is the Short Run and Long Run Shut Down point?
A firm which profit maximises continues to operate in the short run if P > AVC –
When shutting down, no variable costs are incurred by the firm. However, fixed costs have to be paid whether the firm shuts down or continues to produce. This means fixed costs are not considered when a decision to shut down is being made.
The shut-down point is P < AVC, when variable costs cannot be covered. This is at the lowest point on the AVC curve.
When a firm shuts down, it is a short run decision. This means production is only temporarily stopped.
However, in the long run, the firm can leave the industry. This will happen when TR < TC.
Where does the Shut Down Point occur in the short run?
The short-run shut-down point occurs when AVC=AR. Firms shut down when AVC > AR
AR>AVC: each additional unit sold will reduce the size of any losses and go towards covering fixed costs. The firm will be better off continuing to operate as they will be reducing the size of their losses.
Firms will shut down when AVC>AR because every additional unit sold will add to losses.
Where does the Shut Down Point occur in the long run?
The long-run shut-down point occurs when ATC=AR. Firms shut down when ATC > AR
If AR>ATC then each additional unit sold will add to profits. The firm will be better off continuing to operate.
Firms will shut down when
ATC>AR because every additional unit sold will add to losses.
What is meant by Efficiency?
How well a business will use their resources to produce goods + services
What is Static Efficiency?
Refers to how much output can be produced now from a given stock of resources and whether producers are charging a price to consumers that fairly reflects the costs of production
What is Allocative Efficiency?
Looks from the perspective of the consumer
Achieved when the value consumers place on a good or service (reflected in the price they’re willing to pay) equals the cost of the resources used up in production
AR / P = MC
(P=AR= Demand, MC = Supply)
What is Productive Efficiency?
About minimised cost and maximised output; exploiting all economies of scale
All resources are being used, and EoS are exploited. It occurs at the minimum point on the AC curve. It’s good to the consumer if the low cost is passed on to them as a low price
What is Dynamic Efficiency?
Efficiency over a period of time. It focuses on changes in the amount of consumer choice available in markets, together with the quality of G+S available.
Supernormal Profit
Using supernormal Profit to reinvest back into the firm, which they can use to lower unit cost and venture into new areas
What is X Efficiency?
When there is no waste
Any Point on the AC Curve
Libenstein (1966) pointed to potential cost inefficiencies arising from a lack of effective competition within a market. Companies that face no or little real competition often allow their fixed costs to rise (e.g. Monopolies)
What is the Efficiency like in a Perfect Competition?
Short Run Profit: AE ✔️ PE ✖️
Short Run Loss: AE ✔️ PE ✖️
Long Run Equilibrium: AE ✔️. PE ✔️
What is the Efficiency like in a Monopolistic Competition?
Short Run Profit: AE ✖️ PE ✖️
Short Run Loss: AE ✖️ PE ✖️
Long Run Equilibrium: AE ✖️ PE ✖️
What is the Efficiency like in a Monopoly?
Short Run: AE ✖️ PE ✖️
Long Run Equilibrium: AE ✖️. PE ✖️. DE ✔️
What is the Efficiency like in an Oligopoly?
Short Run: AE ✖️ PE ✖️
Long Run Equilibrium: AE ✖️. PE ✖️. DE ✔️
What is the Level of competition in a prefect competition?
High
What are the types of goods which are produced in a perfect competition?
Homogenous
Are they price takers or price makers in a perfect competition?
Price Takers
What barriers to entry/exit are there in a perfect competition?
No barriers
What knowledge of prices do firms have?
Perfect knowledge
How many buyers + sellers are there in a perfect competition?
Many buyers and sellers, (none of whom is large enough to influence price)
What do firms in a perfect competition make in the short run?
Abnormal profit, or a Loss
What do firms make in the long run of a perfect competition?
Normal Profit
How do firms change from the short run to long run in a perfect competition?
Abnormal Profit: Gives an incentive to join the market, which increases supply.
Loss: Gives incentive to leave the market, reducing supply.
What are some examples of markets running in perfect competition?
Foreign Exchange Market
Market Stalls
What type of demand do firms in a perfect competition have?
Perfectly elastic
What does a diagram for a perfect competition look like?
Individual Firm: Elastic demand curve
Whole Market: Supply + Demand Curve, where the equilibrium is at the same price as the individual firm
What does the supply curve look like in a Perfect Competition?
In a perfectly competitive market, the supply curve for a firm is the marginal
cost curve above the average variable cost in the short run, and the average total cost in the long run.
What are the Similarities between Monopolistic Competition and Perfect Competition?
High Competition
Low Barriers to Entry
High Knowledge of Prices
Many Buyers + Sellers
What are the Differences between Monopolistic Competition and Perfect Competition?
MC are price makers, PC are price takers
MC has a downwards sloping demand curve, PC has an elastic curve
MC has slightly differentiated goods, PC has homogenous goods
What is Product Differentiation?
The process of distinguishing a product or service from others, to make it more attractive to a target market
What is Monopolistic Competition like in the Short Run?
Firms make Abnormal Profit, or Loss
What is Monopolistic Competition like in the Long Run?
Firms make Normal Profit
What are some Examples of Monopolistic Competition?
Restaurant business.
Hotels
Pubs
How does a Supernormal Profit making firm in a Monopolistic Competition go to Normal Profit in the Long Run?
In the long run, supernormal profits will be eroded because new firms will enter the market owing to 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.
How does a Loss making firm in a Monopolistic Competition go to Normal Profit in the Long Run?
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
What does a Monopolistic Competition Diagram look like?
Short Run: https://s3-eu-west-1.amazonaws.com/tutor2u-media/subjects/economics/monopolistic_competition_short_run.png
Long Run: https://s3-eu-west-1.amazonaws.com/tutor2u-media/subjects/economics/monopolistic_competition_long_run.png
What is an Oligopoly?
A market dominated by a few producers, each of which has control over the market
What are the Characteristics of an Oligopoly?
- Supply is concentrated in the hands of relatively few firms
- Firms are interdependent, the actions of one firm affects others in the industry
- Goods may be homogenous or differentiated
- Firms often engage in non-price competition
- There are periodic aggressive price wars
- Firms may collude
- Prices are stable
What are some Examples of Oligopolies?
Energy suppliers Commercial banks Pharmaceutical retailers Mobile phones Soft drink manufacturers Supermarkets
What is meant by the Concentration Ratio?
The concentration ratio measures market share of the top ‘n’ firms in an industry
Shares can be by sales, employment, or any other indicators
How to calculate: Just add it up
What are the coefficients of the Concentration Ratio?
High number - the industry is highly concentrated, and dominated by a small number of firms
Low number - the industry is more highly competitive
What type of Demand Curve does an Oligopoly have?
Kinked Demand Curve
Used to illustrate the behaviour of firms in an oligopoly
It consists of 2 demand curves- elastic demand + inelastic demand
The square/rectangle underneath the equilibrium shows Total Revenue
What would happen if a firm in an Oligopoly Increased the Price of their product?
Elastic Curve:
A firm increases the price
Other firms’ rices haven’t changed
Those demanding that firm’s product will new switch to the substitutes
They lose market share (elastic demand- a price inc. will reduce a lot of demand)
What would happen if a firm in an Oligopoly Decreased the Price of their product?
Inelastic Curve:
A firm decreases the price
To prevent competition and loss in market share, the other firms decrease their prices (price war)
The firm’s revenues decrease (inelastic demand)
Why do prices tend to remain Stable in an Oligopoly?
Total revenue is maximise ‘at the kink’.
If price increases and demand is elastic, total revenue falls.
If price decreases and demand is inelastic, total revenue decreases.
As a result of the above, prices tend to remain stable as firms are reluctant to change prices up or down
What is meant by Collusion?
Collusion represents an attempt by firms to recognise their interdependence, and act together rather than compete.
It is a move towards joint profit maximisation