Theory of the firm full notes

Theory of the firm
Revision notes
Objectives
Costs
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Table of Contents
Theory of the Firm .......................................................................................................................... 3 Production in the short-­‐run ................................................................................................................... 3 Costs .................................................................................................................................................... 4 Calculations and curves ......................................................................................................................... 4 Short run production and the law of diminishing returns ..................................................................... 5 Short-­‐run costs ...................................................................................................................................... 5 Average variable cost curve ................................................................................................................... 6 The relationship between MC and AC ................................................................................................... 7 The relationship between the cost curves ............................................................................................. 7 The relationship between average and marginal costs ......................................................................... 7 Extra reading on diminishing returns .................................................................................................... 8 Explain the shape of the MC curve ........................................................................................................ 8 Economies of scale and the long run average curve ............................................................................. 9 Sources of economies of scale ............................................................................................................. 10 Movements along the LRAC curve and shifts in it ............................................................................... 10 The relationship between the SRAC and LRAC .................................................................................... 11 Revenues ......................................................................................................................................... 13 Revenue curves ................................................................................................................................... 13 Profit and revenues curve ................................................................................................................... 14 Normal and abnormal profit ................................................................................................................ 14 Profit maximisation: MC=MR .............................................................................................................. 15 Shifts in cost curves ............................................................................................................................. 16 Shifts in revenue curves ....................................................................................................................... 16 Shut-­‐down point in the short run ........................................................................................................ 16 Objectives of a business ............................................................................................................. 17 How and why firms grow ........................................................................................................... 18 Types of growth: .................................................................................................................................. 18 Types of integration ............................................................................................................................. 18 Implications of growth ......................................................................................................................... 19 Multinational/transnational firms ....................................................................................................... 20 2
Theory of the Firm
Production in the short-run
Assume a firm has been set up to produce furniture and has hired a factory unit and
machinery in order to carry out this production.
No. of workers
1
2
3
4
5
6
7
Total product
3
7
16
28
45
60
63
Average product
3
3.5
5.3
7
9
10
9
Marginal product
3
4
9
12
17
15
3
Initially, the firm has incurred some fixed costs in terms of hiring the factory and the
machinery. The owners of these will expect to be paid for their use, regardless of whether
production has started or not. We also assume ceteris paribus – all other factors other than
price remain fixed, including the quality of the products made.
The short-run is where fixed costs of production cannot change. The long-run is a
period of time where all factors of production are able to change.
As the firm commences production of furniture, we assume that it is in a short-term (run)
situation where at least one FOP remains fixed – here, it’s the size of the premises. To
increase its output, it will take on extra workers and as it does so, it will find, up to a point,
that each worker will add more to the total output than the previous worker, due to
specialisation.
In the table above, the marginal product of worker number 3 is 9, while the MP for worker 4
is 12 – they produce 12 more units as a whole. This is known as increasing marginal returns,
where increasing the amount of the variable factor increases the output more than
proportionally.
As the firm grows and orders increase, it will continue to employ more workers and purchase
more raw materials. However, there will come a point where the premises cannot
accommodate the extra workers and their presence will reduce the output of the existing
workers. The MP rises up until worker 5 (each successive worker adds more to output than
the previous ones) but with worker 6, MP starts to fall. However, average product rises and
as the MP is above the average, it pulls up the average. Employment of the 7th worker only
adds 3 units of output as the fixed factors are now becoming overloaded as there are too
many variable factors for the size of the fixed factor.
In the short-run, the firm can only change its rate of output by combining more or less of the
variable factors with the fixed factor. The table indicates that initially, the firm experiences
increasing returns where output rises more than proportionately to the increase in output, but
then the firm experiences diminishing marginal returns, where the increase in output is less
than proportional to the increase in labour/variable input. This is known as the law of
diminishing marginal returns.
3
In the first diagram, we can see both
diminishing and increasing short-run costs
where the ATC is at the lowest point with
employment of 6 workers. This is known as
the optimal output, the point where the firm
has achieved the lowest cost combination
between fixed and variable factors. This is
also productive efficient – as the firm is
operating at the minimum average cost. If
the firm decided to increase its output and
needs to employ more workers, it will face
increasing costs and will no longer be
productively efficient.
In the second diagram, we can see the
revenues of the firm (output x price) and
average revenue will be at a maximum at an
output of 6 units, where 6 workers are
employed. If the firm produces more output,
its average revenue starts to fall.
Costs
Calculations and curves
Fixed costs: They do not vary with output e.g. rent. They can be contractual – something
you can be forced by a court to pay. As they are not related to output, they need to be paid
even if it produces nothing or runs 24 hours a day.
Variable costs: These costs do vary directly with output. Increasing output will require an
increase in things like raw materials, power and labour. The variable costs of a firm are zero
when there is no output.
Semi-variable costs: These are costs that have both a fixed and variable element to them.
For example, an electricity bill – they have a standing charge plus charge whatever units you
use.
Total costs: This is the addition of the fixed and the variable cost.
Average fixed costs: It can be found by dividing the TFC by the number of output
produced, and diminishes quite rapidly as the costs are spread over an increasing number of
units.
Average variable costs: This is TVC divided by the number produced. It increases as
output increases.
Average total costs: The total cost divided by the number of output produced and declines
as the fixed cost is spread over more units, but then increases as the growth in variable
costs is greater than the fall in fixed costs.
4
Marginal costs: The amount added to the total cost of production by the next unit of output
– essentially, the cost of producing one more unit. The MC is calculated by taking the total
cost and deducting the total cost of the previous unit.
Short run production and the law of diminishing returns
If more workers were added to the kitchen at a busy restaurant, output can raise at a faster
rate than the number of workers employed, because of specialisation. The workers benefit
from this and the division of labour where production tasks are divided amongst the workers.
As the output per worker is increasing with every worker added, the MP of labour has
increased. The MP is the increase in output that results from adding an extra worker to the
labour force.
However, eventually, as more and more workers are combined with the firm’s fixed capital
(which it is in the short-run). The benefit of further specialisation and division of labour
comes to an end. The law of diminishing returns (also known as the law of diminishing
marginal productivity) sets in when the MP of labour starts to fall. That is where one more
worker adds less to output than the previous worker who joined the workforce.
It is this theory that allows us to draw the MP and AP curves:
The concept of diminishing returns
(in the short-run) can also be applied
to costs.
Note: The MP will always cut the AP
at the AP’s maximum point. Also,
there are relationships between the
MP/AP and the MC/AVC curves.
Short-run costs
MC is the cost of producing one more unit of output. The shape of the MC curve is explained
using marginal productivity theory. As long as the marginal productivity of labour is
increasing, then, assuming all workers are paid the same wage rate, the cost of producing
an extra unit falls.
5
This is because the MC of producing every extra unit falls.
Output
Total cost
Marginal cost
1
100
2
180
80
3
250
70
4
300
50
5
380
80
Hence MC falls at low levels of output (where every extra unit has a greater impact on
output) but as soon as the law of diminishing returns sets in, each worker hired adds less to
the total output than the previous worker taken on. Total costs rise faster than output,
leading to a rise in MC.
The shape of the MC curve is based on increasing returns. This occurs where the MC is
falling, at point A and diminishing returns, where the MC is rising, point B. This is important
when we consider the AVC curve and how its shape is affected by the MC curve.
Average variable cost curve
The shape of the AVC curve can also be described using the law of increasing/diminishing
returns. The ACC falls when there are increasing returns (point A) and rises when there are
diminishing returns (point B). The exact shape of the AVC curve depends on the MC curve.
6
The relationship between MC and AC
- When the marginal is > the
average, the average rises
- When the marginal < the
average, the average falls
- When the marginal = the
average, the average is constant
The relationship between marginal and average curves has a number of applications:
• Production theory – MP/AP
• Cost theory – MC/AC/AVC
• Revenue theory – MR/AR
After diminishing returns sets in at point D, the MC curve starts to rise, but the AVC curve
continues to fall. Eventually, the MC curve rises through the AVC curve, causing the AVC
curve to also rise. As a result, the ABC curve is U-shaped, with the MC curve cutting through
it at its lowest point.
The relationship between the cost curves
The AFC falls as output rises. The fall is very rapid as the fixed costs are spread over more
units of output; this will reduce the cost of producing the extra unit. The falling AFC pulls the
MC curve downwards as the cost of producing each unit will fall. But the firm will be taking
on labour, and after some point, the falling fixed cost will be unable to compensate for the
increased labour cost and MC will begin to increase. The MC is shown as cutting the AC at
the lowest point.
The relationship between average and marginal costs
In order to appreciate the relationship, assume that one’s mark for an exam is 15, and the
next exam, one gets 10. The average mark falls. If, instead, one gets 18, the average will
rise. So:
• If the MC is below the average, then it will pull the average down and the average
cost will be falling
• If the MC is above the average, then it will pull the average up
• The MC will always cut AC at its lowest point
• Both of the curves are U-shaped due to the law of diminishing returns. The lowest
point on the MC and AVC shows the point where diminishing marginal returns and
diminishing average returns set in respectively.
7
Extra reading on diminishing returns
When land is initially under-utilised, when population is small and sparse, production is
inefficient because of inadequate labour to work that land. With a sparse population,
specialisation is difficult/impossible, and fixed overheads (i.e. fixed costs) have to be divided
and borne by few people. Some forms of physical capital cannot be used effectively until
more people are available and thus efficiency is in fact improved by adding more labour to
that land. As more units of labour are added to that land/capital, the result is not only rising
total output, but also rising output per extra unit of labour: that is, the extra or marginal
product of labour is rising; the extra output produced by that last unit of labour is greater than
added by his immediate predecessor. This is partly due to labour specialisation – the division
of labour by specialised tasks.
After adding more and more labour to that land, we reach a point of maximum or optimum
efficiency; and then, as we add more labour, we encounter one of the most important
economic laws: the law of diminishing returns. Thus, after that point of maximum efficiency,
each additional or marginal unit of labour added to that fixed stock of land and capital
(technology still constant) will produce smaller and smaller additional marginal units of output
– smaller than that produced by the unit of labour previously added.
Note that we are talking about changes in that extra or marginal product, and not changes in
total output or total product, or even average product, which will continue to rise for some
time after marginal product begins to fall.
Explain the shape of the MC curve
The MC curve shows how costs increase when there is an increase in the level of output in
the short run.
The shape of the MC curve relates to the MP of labour.
As long as the MP of labour is increasing, through the
benefits of specialisation and the division of labour, the
MC of labour will fall, because the MC of producing
every extra unit falls, as labour is becoming more
productive, assuming all workers are paid the same.
This is because the firm benefits from increasing
returns from each extra unit added. As MP rises, due
to increasing returns, MC will fall because the cost per
unit will fall as labour is becoming more productive.
Above, we see that as MC falls dramatically at the start
(OA) as the firm benefits from specialisation,
increasing output, therefore increasing returns as per
the MP curve, as every extra unit of input adds a
disproportionate amount to output.
8
After point A, we see diminishing returns setting in. Diminishing returns occur where the MP
of labour falls as every extra unit of labour becomes less efficient that the last unit added,
causing the MP to fall, therefore the cost per unit to rise. Hence, after point A, diminishing
marginal returns sets in, causing the MC to rise and the MP to fall.
Thus, the shape of the MC curve, in the short run, is dictated initially by increasing and then
ultimately diminishing returns to scale.
Economies of scale and the long run average curve
In the long run, all factors of production are available. This has the effect on costs as output
changes. To start with, long run costs fall as output increases, economies of scale are then
said to exist. E.g. a firm quadruples its output from 10,000 units to 40,000, however, total
COP only increase from 10,000 to 20,000. The average COP consequently falls from £1 per
unit to 50p per unit.
Economists have found that firms do experience economies of scale. As firms expand in size
and output, their long term average costs tend to fall. At some point, which varies from
industry to industry, long run average costs become constant. However, some firms become
too large, and their average costs begin to increase – diseconomies of scale. For example, a
firm may double its output, but costs triple.
In the above, output levels up to OA mean that the firm will enjoy falling long run average
costs and therefore experience economies of scale. Between output levels OA and OB,
LRAC are constant. To the right of OB, LRAC rises and the firm faces diseconomies of
scale. Shifts in the LRAC (up or down) come from changes in the prices of raw materials or
wage rate. E.g. if wage rates fall, LRAC will move downwards and conversely, if wage rates
rise, LRAC will move up.
Optimal level of production: The firm is productively efficient when production takes place at
the lowest cost – this is at bottom of the curve, where there are constant returns to scale.
(The optimal level is represented by AB). The minimum efficient scale is where the output
level is at the lowest COP starts. In the diagram, it is A. To the left of A, the LRAC are
higher, to the right, they are the same or increasing.
9
Sources of economies of scale
1. Purchasing and marketing economies
The larger the firm, the more likely they will be able to buy raw materials in bulk. In doing so,
they are often able to secure lower prices for their factor inputs. Larger firms are also able to
enjoy lower average costs from marketing economies e.g. brand awareness on TV.
2. Managerial economies
By employing specialist staff who have been trained in specific areas, they are able to lead
efficiencies and lower costs due to their training and expertise.
3. Financial economies
Firms often find it difficult to raise finances for new investments, smaller firms often pay
higher interest rates, while larger ones pay lower interest rates.
4. Technical economies
Economies of scale can exist due to increasing and decreasing returns. These are from the
production process e.g. using machinery for the maximum amount of time available e.g. a
cement mixer for 5 out of 5 days. Large scale production is often more productively efficient.
Diseconomies of scale
These arise mainly due to management problems, cultural problems, issues with coordination and communication. Firms try to complete with these issues through
decentralisation.
Movements along the LRAC curve and shifts in it
The LRAC curve is a boundary – it represents the minimum levels of average costs
attainable at any given level of output. Points below the LRAC are unattainable; whilst those
above indicate that a firm is producing goods inefficiently. An increase in output is shown by
a movement along the LRAC curve.
Factors shifting the LRAC curve
• External economies of scale
o When there is growth in the size of the industry in which the firm operates e.g.
which leads to an improvement in infrastructure, other firms may train staff
which the new firm within the industry poaches
• Taxation
o When the government imposes a tax, costs will rise, shifting the LRAC
upwards
• External diseconomies of scale
o This occurs when a firm expands too quickly – they compete with each other
in a small market
• Technology
o New techniques, which will make a firm more efficient – it will decrease LRAS
downwards
10
The relationship between the SRAC and LRAC
In the short run, at least one FOP is fixed. SRAC fall at first, and then begin to rise because
of diminishing returns. In the long run, all factors of production are variable. Long run
average costs change because of economies and diseconomies of scale.
Explanation 1
From short run cost curves to long run cost curves
A short run average cost (SRAC) shows the minimum cost per unit for different levels of
output given a fixed factor, e.g. given 10 machines. There will be an infinite number of short
run curves depending on the constraint, e.g. one SRAC for 11 machines, one for 13
machines and so on. As the firm changes its fixed factor over time, e.g. buys another
machine, this is shown by a new SRAC curve.
• If when the firm expands, it moves on to a new lower SRAC curve, it is experiencing
internal economies of scale
• If when the firm expands, it moves on to a LRAC at the same level, it is experiencing
constant returns to scale
• If when the firm expands, it moves onto a higher SRAC curve, it is experiencing
diseconomies of scale
11
Explanation 2
Long run costs
The long run is defined as a period when the enterprise can alter its scale of plant (either
expand or contract size). All FOP thus become variable. It is likely that, as the scale of plant
increases, the enterprise may enjoy the benefits of internal economies of scale. When these
are achieved, the ATC in the long run (LRAC) is likely to fall.
Points A, B and C represent points on the LRAC curve. Note that these do not necessarily
correspond to the minimum point on each SRAC curve e.g. point X. All points on the LRAC
show the least cost or minimum attainable average cost of production for any given output,
assuming the firm is able to adjust its scale of plant accordingly. In the basic microeconomic
theory of the firm, the assumption is that firms will always choose the least-cost method of
production in the long run and hence move out along the LRAC curve if this is possible, (lack
of finance or lack of demand may prevent the firm from moving along this curve as it would
lack to do). It is important to remember that increasing and diminishing returns to a variable
factor e.g. labour is the most important factor affecting the AC, AVC and MC in the short-run.
Equally, the LRAC curve is strongly affected by economies and diseconomies of scale.
12
Revenues
The different types of revenues
• How we can calculate it: Total Revenue = Quantity x Selling price
• Average revenue: Total Revenue divided by the units sold
• Marginal revenue: Receipts from extra unit
Revenue curves
Different curves can be drawn from the different assumption about average revenue.
What happens to revenues when the price stays the same?
One assumption is that a firm receives the same price for each good sold. As the price is the
same however many units are sold, this must also be equal to the average revenue. The
total revenue increases as total sales increase. The marginal revenue, the additional
revenue from each unit sold is also the price at which it is sold.
Note that because the price of the good remains the same, the average and marginal curves
are identical. The line is also horizontal showing whatever the level of output, average and
marginal revenue remains the same at the price level at which it is set. The average revenue
curve is also the demand curve, because it shows the relationship between average price
and quantity sold. Thus, at any quantity sold, MR=AR=D.
What happens when a firm has to lower its price to attract sales?
A firm needs to lower its price to attract sales. So the AR or average price is falling as sales
get larger. Eventually, total revenue will start to fall – the loss in revenue, from having to
accept a lower price, more than outweighs the increase in revenue from extra sales. As a
result, the MR becomes negative. Each extra unit sold brings negative extra revenue.
13
This TR curve rises at first, then it falls. The AR curve, as well as the MR curve, are
downward sloping, but the latter slopes more steeply than the AR curve. The AR curve is
also the demand curve because it shows the relationship between average price and
quantity sold, so average revenue equals demand.
Revenue and price elasticity of demand (PED)
When the price received by a firm for a good is constant, the AR, MR and demand curves
are identical – horizontal. This means that the PED for the good is perfectly elastic, whatever
the percentage change in quantity demanded of the good, there is no change in the price.
However, when the price of a good declines, as sales increase, there is likely to be a change
in the PED along the AR curve. If a good was price inelastic, a rise in the price would
increase spending by consumers which will increase revenue for the firm. Revenue would
increase as the increase in price would compensate for the decrease in quantity demanded
for the price change.
If the demand is price elastic, then a percentage change in price will bring about an even
larger fall in quantity demanded, resulting in a fall in revenue. This can be seen in the
previous diagrams. Demand is price elastic because falls in price are resulting in rises in TR.
At sales levels above this, demand is price inelastic, falls in price results in a fall in revenue.
In terms of MR, demand is price elastic so long as MR is positive i.e. TR is rising. When MR
is negative, demand is price inelastic and can be seen above. The AR is also the demand
curve for the good. The top half of the curve shows the demand as being price elastic.
Profit and revenues curve
Profit is defined as the difference between revenues and costs. A firm will make maximum
profit when the difference between them is the greatest. The breakeven point for a firm is
where TR=TC.
Normal and abnormal profit
Cost for an accountant is different for that of an economist. The economic cost of production
is the opportunity cost. It is measured by what could have been gained if the resources were
employed in the production process could have been used elsewhere in their next most
profitable use. If a firm could have made £1m in profit by using its resources in the next best
banner, then the £1m profit is an opportunity cost for the firm. We call this the normal profit.
This is the amount required to keep all FOP from moving to another project. If the firm failed
to earn normal profits, it would cease to produce in the long run. The firm resources would
be put to better use producing other goods and services where normal profit could be
earned. Hence, normal profit must be earned if FOP are to be kept in their present use.
Abnormal profit (aka pure profit, economic profit or supernormal profit) is the profit over and
above normal profit (i.e. the cost over and above the opportunity cost of the resources used
in production by the firm). It is important to remember that the firm earns normal profit when
TR=TC. TR must be greater than TC if it is to earn abnormal profit.
14
Profit maximisation: MC=MR
MC and MR can also be used to find the profit maximising level of output. MC is the addition
to TC of the number of extra unit of output. MR is the increase in TR, resulting from an extra
unit of sales. So long as the firm can make additional profit from producing an extra unit of
output, it will carry on expanding production. However, it will cease extra prodction when the
extra unit yields a loss (i.e. where the marginal profit moves from positive to negative). This
happens when the unit contributes nothing to abnormal profit. Economic theory states that
profits will be maximised at the output level where MC=MR.
Costs and revenues
These same points can be made using cost and
revenue curves. The revenue curves here are drawn
making the assumption that the firm receives the same
price for its product however much it sells (i.e. demand
is perfectly elastic). So the total revenue curve
increases at a constant rate. The MR curve is
horizontal, showing that the price received for the last
unit of output is exactly the same as the price received
for all the other units sold before.
The TR and TC curves show that the firm will make a
loss if it produces between O and B. TC is higher than
TR. B is the breakeven point. Between B and D, the
firm will make a profit because TR is greater than TC.
However, profit is maximised at the output level C
where the difference between TR and TC is at a
maximum. If the firm produces more than D, it will start
to make a loss again; it is the maximum amount of
output a firm can make without it making a loss.
Therefore, D is the sales maximisation point subject to
the constraint that the firms should not make a loss.
Output OC is the point where MC=MR. If the firm produces an extra unit above OC, then the
MC of production is above the MR received from selling the extra unit. The firm will therefore
make a loss on that extra unit and total profit will fall. On the other hand, if the firm is
producing to the left of OC, the cost of an extra unit of output is less than its MR. Therefore,
the firm will make a profit on the extra unit if it is produced.
Therefore, we can saw, the firm will expand production if the MR is above the MC. The firm
will reduce output if the MR is below MC.
It should be noted that there is another point in the diagram where MC=MR – this is at point
A. It is not always the case that the MC will start above the MR curve at the lowest point of
output. However if it does, then the first intersection point of the two curves, when MC is
falling, is not the profit maximisation point. The MC=MR rule is therefore a necessary but not
sufficient condition for profit maximisation, a second condition needs to be attached, namely
that MC must be rising as well.
15
Shifts in cost curves
•
Due to the increased price of raw materials, the MC of production will be higher, and
the profit maximisation level will fall. In this case, the MC curve will shift to the left.
Shifts in revenue curves
•
If revenue increases, output generally increases. E.g. if consumers are willing to pay
more for a product, this will increase MR, and the profit maximising level will be
higher.
Shut-down point in the short run
Firms are not always able to operate at a profit. They may be faced with operating at a loss –
neo-classical economists predict that firms will continue in production in the short run so long
as they cover all of their variable costs.
Period
TVC
TFC
TC
TR
1
2
3
4
5
30
30
30
30
30
20
20
20
20
20
50
50
50
50
50
60
50
40
30
20
If production
takes place
+10
0
-10
-20
-30
If plant is shut
down
-20
-20
-20
-20
-20
The company would lose £20m in any period in which it shuts down its plant and produced
nothing. This is because it still has to pay its fixed costs of £20m even if output is zero. TFC
represents the maximum loss per period the company needs to face. As trading declines,
the costs remain the same, so in period 1, TR exceeds TC. The firm makes a profit of 10m if
production takes place. In period 2, it makes no profit by operating its plant (although
consider that costs include an allowance for normal profit – it is within the costs).
However, this is better than the alternative of shutting down and making a £20m loss. So too
is producing in period 3. Although the company makes a loss of £10m, it will continue to
produce because the alternative is not producing, which is a loss of £20m. In period 4, the
company is on the dividing line between whether to produce or not. In period 5, the company
will clearly not produce – its operating losses would be greater than if the plant were to shut
down.
So short run profit maximisation implies that a firm will continue even I fit is not fully covering
its total cost. It will only shut down production when its TR fails to cover its TVC.
16
Objectives of a business
Profit is probably a firm’s only goal.
• Large organisations generally have a ‘mission’ – a statement of the company’s basis
reason for existence. This will never be expressed as maximising profit, but perhaps
as something as vague as ‘to serve customers.’
• Large companies have many departments, headed by individuals with their own
objectives which may or may not coincide with official company objectives. What is
ultimately decided may be the result of plotting and scheming between alliances of
departmental heads. There may be a variety of targets which a firm tries to achieve
one after another.
• A firm in an oligopolistic industry is unlikely to be able to pursue profit maximisation in
a simple way since there is always a danger of triggering an unfavourable response
from rivals
• Firms may be members of trade associations (illegal) which have been formed to
minimise competition. Here, the objective is often to gain the highest possible profits
for the group rather than the individual firm
• Nationalised industries are supposed to be operated ‘in the public interest’ which
means that some loss making activities may continue
• There is growing awareness that it is not only shareholders who have a ‘stake’ in an
organisation. Other stakeholders include the workers, customers, and the local
community. Their interests may prevent profit maximising activity from taking place.
• There is increasing emphasis on ‘ethical management’ – firms avoiding things which
may be profitable but are ‘wrong’ e.g. environmental exploitation, use of child labour
in developing countries. Many firms seem to take action which will reduce their profits
but which will benefit the wider community – corporate social responsibility.
• It should be remembered that the achievement of a large profit may not be the result
of efficiency but of the exploitation of the public by an organisation with a great deal
of monopoly power.
17
How and why firms grow
Types of growth:
•
Growth of firms classified into two categories:
o Internal growth: when a firm becomes larger by expanding in its current
market or finding new markets i.e. Easyjet
o External growth: Refers to the integration of two formerly separate firms.
Integration can take in the form of a voluntary merger or contested takeover
Types of integration
Horizontal
• Integration between firms at the same stage of production or distribution
• Mergers become a logical option e.g. in the TV industry, due to the changing nature
of TV such as the emergence of digital broadcasting and the competition from cable
and satellite channels
• The concern of this in terms of the TV industry is that one company could have
enormous selling power when it comes to selling advertising time as it would become
the biggest commercial broadcaster in the UK
• Following on from this, a concern is that the market may be likely concentrated, with
a significant portion of the market being controlled by the merged company
• Thus, mergers may not be in the public’s interest
• Ownership of the market by one firm could lead to higher prices
• Significant horizontal mergers include: Supermarket takeover by Morrison’s of
Safeway. Controversially, Lloyds TSB took over HBOS which was negotiated by the
government in the 2008 crisis. It is normally not allowed due to competition issues
and the combined market share of 40%, but national interest took precedence over
public interest.
Vertical
• Integration between firms at different stages of production or distribution
• If the firm taken over is at the next stage of production or distribution process (e.g.
brewery buying a chain of pubs) then this integration is known as forward-vertical
• If a brewery bought a hops farm, this would be backward-vertical integration
• Vertical integration is common within the media industry
• Airlines owning airports is backward vertical
Conglomerate
• Integration between firms that are in different, unrelated industries. These firms are
said to be diversified
• They are less common than they were in the 1960s and 1970s – many large
diversified conglomerates that grew through acquisition have been slimmed down in
recent years to concentrate on core activities
• Disappeared in the new century, but Indian giant Tata Group is a modern day
example – involved in 7 different sectors including steel, teas, construction, hotels
and cars
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Lateral
• Integration between firms that are in different, related industries
• E.g. Acquisition of Gillette by Procter and Gamble in 2004 was an example of 2 firms
selling household goods
• Can be beneficial in providing opportunities for economies of scope
• Recently, it has been popular for firms to cooperate in alliances and joint ventures
• Star Alliance and One World are 2 groups of airlines which are integrated worldwide
as air transport networks
• Globalisation, increased airline competition, and changes in passenger demands for
air travel have meant that a single airline cannot sustain and respond alone to these
changes
• Can be used to challenge other firms i.e. Airbus jointly owned by EU aircraft
manufacturers vs. Boeing in US.
• Joint activities by firms give them many advantages of a merger especially those
linked to economies of scale, without them losing their separate legal identity
Market concentration
• The extent to which a small group of firms controls a given percentage of output or
sales can be measured by the use of a concentration ratio
• A single concentration measure for a particular industry could be a ‘4 firm conc. Of
85%’ meaning that the 4 largest firms in an industry accounting for 85% of total
output
• Horizontal mergers tend to increase market concentration. Markets with a high level
of concentration often give increased market power to the largest firms with some
control over price
• Highly concentrated markets are often called oligopolies
• Some markets with a low level of concentration e.g. Women’s clothing are very
competitive
Implications of growth
External growth has a number of attractions for the firm.
Rapid growth and acquisition of market power
• Integration offers possibilities of increased market share and acquisition of valuable
brand names. Recently, became common for a sum representing the values of a
brand name to be included as an asset in the balance sheets of firms, despite being
an intangible asset. Acquiring brand names and market share through integration
may prove cheaper and quicker, than the alternative of internal growth.
Economies of scale
• Expansion of output in the case of horizontal integration offers potential for lower LR
average costs from a wide range of sources (technical, managerial, commercial,
financial and risk-bearing economies of scale). E.g. the horizontal mergers that have
produced GlaxoSmithKline Beecham has given the firm significant research
economies of scale in the pharmaceuticals sector
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Diversification
• Conglomerate and lateral integration takes firm into different product areas, making
them better able to withstand a slump in any one market, while horizontal integration
can give more geographical or brand diversification.
• Integration is not always a success, the potential for diseconomies of scale should be
considered, and many mergers in the past proved to be unsuccessful by post-merger
profitability, with the profit made by the new, larger company falling short of the
combined profits of the previously separate firms
• When Morrison’s took over Safeway, there was not a perfect synergy as
management and financial cultures differed, but there was a strong chance of
success.
• Some companies have resulted in de-emerging to improve performance. E.g.
Daimler-Chrysler as cultures between the two were different at management level
From an economy’s point of view, integration is often regarded as detrimental:
1. It can confer a degree of monopoly power, which the neo-classical structure conduct
performance suggests will lead to exploitation of consumers
2. Post-merger rationalisation often leads to a direct loss of jobs
3. Research by an economist found that two third of mergers in the US reduced
shareholder value
Despite this, integration can sometimes receive government encouragement as domestic
firms may need to be large to compete internationally. But internal growth is generally held in
more favourable regard than external growth – especially if it entails product innovation.
Trend towards demerger
• Since the 1990s, trend towards the breakup of larger companies began to emerge –
difficulties inherent in managing large firms, especially conglomerates have been
recognised, and that many companies saw the benefits in becoming ‘more focused’
on particular lines of business
• Failed mergers can lead to more demergers
Multinational/transnational firms
1. A multinational is an enterprise which controls production or service facilities in more
than one country
2. Originally, most multinationals were European, becoming involved in backward
integration in colonies. In the 1950s and 1960s, American multinationals developed
in importance. In the 1970s and 1980s, there was much Japanese investment in the
West. Opportunities have increased with governments of former planned economies
allowing western firms to operate within the economy, in some case by joint ventures.
Now, virtually all large western firms are multi-nationals.
3. The world production of tyres, cars, petroleum and pharmaceuticals is controlled by a
handful of massive firms
4. There has been much criticism of the operation of multinationals
• Much of world trade is not between countries but between elements within a
multinational corporation e.g. Ford UK trading with Ford Germany. These
trading decisions have a major effect on a nation’s employment and trade
position
• Trade may take place at artificial ‘transfer prices’ designed to minimise tax
payments
• Companies play off national governments to maximise concessions
• Domestic anti-monopoly controls may be avoided by expanding abroad
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Domestic workers can always be threatened by the removal of production to
cheap labour countries
5. There are benefits:
• The company can spread risk
• New skills, employment and technology can be spread to developing nations,
however:
• Many raw materials and key components may still come from the
original site with new factories only being assembly plants
• Key workers may be imported
• The new technology imported may not be appropriate to a third world
nation and so cannot be transferred to the rest of the economy
• Old style domestic activity may be destroyed
• Dualism may develop with a small westernised ‘elite’
• At times of recession, such plants are vulnerable to closure.
•
The WTO, which attempts to remove barriers to world trade, is seen by many protesters as a
vehicle for allowing world domination by large western multinationals at the expense of
smaller scale producers in the developing world.
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