Economics - Cost Revenue Profit Ppt

The firm’s revenue

Total, average and marginal revenue }  A firm’s revenue are it’s receipts of money from the sale

of goods and services over a time period such as a week or a year.

}  Total revenue (TR) is the total amount of money received from the sale of any given level of output. It is the total quantity sold times the average price received.

}  Average revenue (AR) is the average receipt per unit sold. It can be calculated by dividing total revenue by the quantity sold.

}  Marginal revenue (MR) is the receipts from selling an extra unit of output. It is the difference between total revenue at different levels of output.

Revenue curves – perfectly competitive market

}  In a perfectly competitive market: }  There are many buyers and sellers in the market. Buyers and

sellers are said to be price takers. }  There is freedom of entry and exit from the industry. }  Buyers are sellers possess perfect knowledge of prices. }  All firms produce a homogenous product. There is no branding

of products and products are identical.

Revenue curves – perfect competition

Pric

e To

tal

reve

nue

Output

Output

In a perfectly competitive market all firms receive the same price for each good sold (P1).

As the price is the same however many units are sold, this must also equal average revenue (P=AR).

The AR curve is the demand curve because it shows the relationship between price and quantity sold. The demand curve is perfectly elastic.

The marginal revenue, the additional revenue from each unit sold, is also P1.

At any quantity sold, MR=AR=D.

The total revenue curve is linear and upward sloping as sales increase.

D=AR=MR

TR

Refer to Anderton, Table 1 and Figures 1 and 2 on pp.282-283.

P1

Revenue curves – imperfect competition

Pric

e To

tal

reve

nue

Output

Output

In an imperfectly competitive market goods are not homogenous.

Therefore, the demand curve is downward sloping. A firm has to lower its price in order to achieve higher sales.

The AR curve is also the demand curve because it shows the relationship between price and quantity sold. Average revenue, or average price, is falling as sales get larger.

The marginal revenue curve is also downward sloping.

Mathematically, the slope of the MR curve is twice as steep as the AR curve (measuring the distance horizontally on the graph is, MR is always exactly half of AR).

D=AR

TR

MR


Pric

e To

tal

reve

nue

Output

Output

D=AR

TR

Refer to Anderton, Table 2 and Figures 3 and 4 on pp. 283-284. Complete Question 1, p.283.

Q1

MR

The total revenue curve for a firm will peak where MR=0.

As sales increase, the extra revenue gained (the MR) is falling. Total revenue is therefore increasing, but at a decreasing rate.

TR is maximised when MR=0. At this point no extra revenue is gained from the sale of an additional unit.

Units sold beyond this point bring in negative MR which leads to falling TR.

Thus, TR is maximised when MR=0 at output Q1.

Revenue and price elasticity }  When the average revenue curve (or demand curve) of a

firm is downward sloping there is likely to be a change in elasticity of demand along the average revenue curve.

Pric

e (£

)

Quantity 0

E = infinity

E = 1

E = zero


Pric

e To

tal

reve

nue

Output

Output

D=AR

TR

Q1

MR

If demand is price inelastic, the percentage fall in quantity demanded in less than the percentage rise in price and total revenue will increase.

Conversely, if demand is price elastic, then a percentage rise in price will bring about an even larger percentage fall in quantity demanded. As a result there will be a fall in total 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.

Price elasticity is 1 or unitary when total revenue is maximised. This is when marginal revenue is zero.

E = infinity

E = 1

E = zero

SR Cost of Production

The firm’s short run costs of production

What is ‘a firm’? }  The firm is the economic organisation that

transforms factor inputs into goods and services for the market.

}  It has particular objectives such as: }  profit maximisation }  the avoidance of risk-taking }  the achievement of long term economic growth

}  A firm may be a sole trader with a small factory or corner shop or a large multinational corporation with plants and businesses all over the world.

}  In economic theory, all firms are headed by an entrepreneur.

Costs of production

}  In an accountant’s view, a firm’s costs are production expenses paid out at a particular time and price.

}  However, an economist’s view of costs is wider than this.

}  In addition to the money paid out to factors, an economist’s definition of costs also includes the opportunity costs of employing the different factors such as financial capital and labour.

Anderton, question 1, p.271.

Normal profit }  Profits are what is left when the expenses are deducted

from the firm’s income or sales revenue. }  The entrepreneur will expect a minimum level of profit,

reflecting what his or her capital and labour would have earned elsewhere.

}  This is the concept of normal profit. }  Economists regard this element of the entrepreneur’s

reward as a cost of production, because without it there would be nothing produced by the firm.

Example of normal profit

}  Suppose he could have earned $50 working another job for the day (the next best alternative forgone).

}  The $50 is therefore his normal profit – the profit that is just sufficient to ensure that he will continue to supply his existing product to the market.

}  Hence, the opportunity cost of his labour must be included as an economic cost of production.

}  A market trader may calculate that he has made $50 ‘profit’ on the day’s trading.

}  However, this may not include the value of his own time.

Abnormal profit }  Therefore, profit to an economist is:

}  Total revenue minus total cost (including normal profit).

}  If this is positive, then it is abnormal profit. }  The possibility of making abnormal profit motivates the

entrepreneur to take the business risks in supplying goods and services to the market.

Short run costs }  Fixed costs: These are costs which are completely

independent of output (e.g. rent, factories, machinery, advertising, rates). As production levels change, the value of a fixed cost will remain constant.

}  Variable costs: These include any costs that are directly related to the level of output (e.g. labour, raw materials and components, electricity).

}  In the short-run, at least one factor input of production is fixed. In the long run, all costs will be variable costs.


Total cost }  Total cost (TC) equals total fixed cost (TFC) plus total

variable cost (TVC) }  Increased production will almost certainly lead to an

increase in total costs (they may need to by more raw materials, increase the number of workers, and increase factor inputs).

}  Note that total fixed costs remain constant and all levels of output in the short-run, even when output is zero.

Anderton, Table 1, p.272.

Average cost of production }  The average cost of production is the total cost divided

by the level of output.

average fixed cost (AFC) output

total fixed cost =

average variable cost (AVC) output

total variable cost =

average total cost (ATC) output

total cost =

Anderton, Table 2, p.272.

Marginal cost }  Marginal cost is the addition to the total cost when

making one extra unit of output. }  Marginal cost is therefore a variable cost. }  For most firm’s the decision to increase output will raise

the total cost, that is, the marginal cost will be positive as extra inputs are used.

}  Firms will only be keen to do this when the expected sales revenue outweighs the extra cost.

MC Q

TC =

Anderton, Table 3 p.273.

Anderton, Question 3, p.273.

Diminishing returns and short run costs

}  Rising marginal cost is a reflection of the principle of diminishing returns.

}  In the short run a firm will be faced with employing at least one factor input which cannot be varied.

}  As more of the variable factors are added to the fixed ones (to increase output), the contribution of each worker to the total output will begin to fall.

}  These diminishing marginal returns cause marginal and average variable cost to rise.

Anderton, Questions 4, p.273.

The shape of the average and marginal cost curves is determined by the law of diminishing returns. Diminishing marginal returns set in at an output level of 145 when the marginal cost curve is at its lowest point. Diminishing average returns set in at the lowest point of the average variable cost curve at an output of 210 units. Note that the MC and AC curves are mirror images of the MP and AP curves (but only if there are constant factor costs per unit).

Short run cost curves (MC, AC, TC)

Cos

ts

Cos

ts

MC

Output

Output

Note that the MC curve cuts the AC curve at its lowest point.

AC

TC


LR Cost of Production

The firm’s long run costs of production

Long run average costs }  In the long run all factors of production are variable. This

has an effect on costs as output changes: }  Economies of scale are said to exist – average costs fall as

output increases. }  Diseconomies of scale may set in – some firms become too

large and average costs begin to rise.

Economies of scale and LRAC Cos

t pe

r un

it

Output

LRAC

0

Internal economies of

scale

diseconomies of scale

At first, long run average costs fall as output increases because of economies of scale.

Then average costs are constant over the output range AB.

Then average costs rise when output exceeds 0B showing diseconomies of scale.

Output range AB is the optimum level of production.

A B

Economies of scale and LRAC Cos

t pe

r un

it

Output

LRAC

0

Internal economies of

scale

diseconomies of scale

A B

The LRAC curve is drawn given a set of input prices and costs. If the cost of raw materials in the economy rose, there would be a shift upward in the LRAC curve.

Similarly, a fall in wages in the industry would lead to a downward shift in the LRAC curve.

The optimum level of production }  The output range over which long run average costs are

at a minimum is said to be the optimal level of production.

}  The output level at which lowest cost production starts is called the minimum efficient scale (MES) of production.

}  The MES is point A in the previous diagram.


Sources of economies of scale

Technical economies }  Economies and diseconomies of scale which exist because of

increasing and decreasing returns to scale are known as technical economies.

}  Technical economies arise from what happens to the production process (e.g. larger firms are able to make better use of equipment) and plant size (e.g. the average cost of production of a car plant making 50,000 cars a year will be less than that of one making 5,000 cars a year).

Sources of economies of scale Managerial economies }  Specialisation is an important source of greater efficiency. }  Larger firms are able to specialise by employing specialist

staff which is likely to lead to greater efficiency and therefore lower costs.

Purchasing economies and marketing economies }  Larger firms are in a better position to be able to

negotiate lower prices for their factor inputs. }  Larger firms are able to enjoy lower average costs from

their marketing operations (e.g. a 30 second TV commercial for a product which has $10 million per annum costs is the same as a 30 second TV commercial for one which has sales of only $5 million per annum).

Sources of economies of scale Financial economies }  Large firms have a wide range of financing options

available to them and are likely to receive relatively low rates of interest because banks know that they are less risky than smaller firms.

Sources of diseconomies of scale Management problems }  Diseconomies of scale arise mainly due to management

problems, e.g. poor communication or disagreements between departments, duplication of jobs or tasks, time taken to make decisions

}  Labour problems may also exist, e.g. low staff morale and motivation, workers shirking on their jobs and responsibilities, strikes and disruptions may occur if the workers feel they are poorly treated.

Sources of diseconomies of scale Geographical problems }  If a firm has to transport goods over long distances

(whether finished goods or raw materials) because it is so large, then average costs may start to rise.

}  Head office may also find it far more difficult to control costs in an organisation 1,000 miles away than in one on its door step.

}  http://www.youtube.com/watch?v=XJ7IIOye7H4


Mercadona

}  Mercadona is a low-priced supermarket in Spain. Listen and read the article from the Economist and identify the benefits to Mercadona of it large scale of production.

}  Are there any disadvantages to its large scale of production?

The LRAC curve as a boundary Cos

t pe

r un

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Output

LRAC

0

Attainable

A

B

The LRAC curve is a boundary between levels of costs which are attainable and those which are unattainable.

If a firm produces on the LRAC curve , then it is producing at long run minimum cost for any given level of output, such as at point B. Point A is within the LRAC and therefore inefficient.

Movements along the LRAC curve }  An increase in output which leads to a fall in costs would

be shown by a movement along the LRAC curve. }  This would result from the internal economies/

diseconomies of scale. }  However, there are a variety of reasons why the LRAC

might shift.

Shifts in the LRAC curve }  External economies of scale }  External diseconomies of scale }  Taxation }  Technology

External economies of scale }  External economies of scale arise when there is a growth

in the size of the industry in which the firm operates. }  For example:

}  The growth of a particular industry in an area might lead to the construction of a better local road network, which in turn reduces costs for individual firms.

}  A firm might experience lower training costs because other firms are training workers which it can then poach.

}  The local government might provide training facilities free of charge geared to the needs of a particular industry.

}  External economies of scale will shift the LRAC curve of an individual firm downwards.

External diseconomies of scale }  External diseconomies of scale occur when the industry

expands quickly. Individual firms are then forced to compete with each other and bid up the prices of factor inputs like wages and raw materials. This will shift the LRAC curves of individual firms in the industry upwards.

}  External diseconomies of scale may exhibit themselves in the form of: }  traffic congestion which increases distribution costs; }  land shortages and therefore rising fixed costs; }  shortages of skilled labour and therefore rising variable costs.

Other factors shifting the LRAC curve }  Taxation: If the government imposes a tax upon an

industry, costs will rise, shifting the LRAC curve of each firm upwards.

}  Technology: The introduction of new technology in an industry which is more efficient than the old will reduce average costs and push the LRAC curve downwards.


The relationship between the SRAC curve and the LRAC curve

}  In the short run, at least one factor is fixed. Short run average costs fall and then begin to rise because of diminishing average returns.

}  In the long run, all factors are variable. Long run average costs change because of economies and diseconomies of scale.

}  In the long run, a company is able to choose a level of production that will maximise profits.



t pe

r un

it

Output 0

A

J

Points A, D and G show the long run cost curves at different levels of production.

If the firm in the short run then expands production, average costs may fall or rise to B, E or H respectively. C, F and J are the long run costs when all factor inputs are variable.

D

C H

F

E G

B SRAC1

SRAC3

SRAC2

P Q R S


t pe

r un

it

Output

LRAC

0

A

J

The LRAC curve is said to be the envelope for the short run average cost curves because it contains them all.

D

C H

F

E G

B SRAC1

SRAC3

SRAC2

Anderton, Data Questions 1-3, p.281.

Minimum efficient scale }  A firm that is producing at its optimum output in the

short run and the lowest unit cost in the long run (sometimes called the minimum efficient scale), has maximised its efficiency.

}  Industries where the minimum efficient scale is low will have a big population of firms.

}  Where it is high, competition will tend to be between a few large players.

Bamford, self-assessment task, questions 1-2, p.154.

The firms objectives

A firm and the industry }  A firm is a business organisation that buys and hires

factors of production in order to produce goods and services that can be sold at a profit.

}  Types of firm might include: }  sole traders }  partnerships }  co-operatives }  private and public limited companies }  state-owned firms }  multinational firms

The firm }  Firms can range from small simple organisations to large

complex, multinational organisations. }  The characteristics and behaviour of a firm depend on the

type of economic activity and the nature of the competition.

}  The factor mix in forms varies enormously, with some firms being highly labour intensive in and others more capital intensive.

}  The decisions firms take depends on the cost and availability of factors of production in different economic systems.

The industry }  In a competitive market structure, the industry is simply the

sum of all the firms making the same product. This is the total market supply.

}  In other markets, the industry is taken to be the total number of firms producing within the same product group, i.e. things which are close substitutes with each other.

}  In reality many multi-product firms operate in more than one industry at the same time.

}  The industry is therefore a collection of business organisations which supply similar products to the market.

}  A firm’s market share is the sales of the firm divided by the total sales of the entire industry.

The firm’s objectives }  Profit maximisation }  Sales revenue maximisation }  Sales maximisation }  Satisficing profits

Normal and abnormal profit }  Normal profit is profit that is just sufficient to ensure that

a firm will continue to supply its existing good or service. }  Abnormal profit is a profit greater than that which is just

sufficient to ensure that a firm will continue to supply its existing product or service.

}  Firms earn normal profit when total revenue is equal to total cost.

}  However, total revenue must be greater than total cost if it is to earn abnormal profit.

Profit maximisation: the MC=MR rule }  Marginal cost is the addition to total cost of one extra

unit of output. }  Marginal revenue is the increase in total revenue resulting

from an extra unit of sales. }  Marginal revenue minus marginal cost gives the extra

profit to be made from producing one more unit of output.

Profit maximisation: the MR=MC rule

Quantity TC MC Price

0 20

1 30

2 35

3 45

4 60

5 90

6 130

0

5

10

15

30

10

50

Costs and revenue MC

Output

20

20

20

20

20

20

20

D=AR=MR

In a perfectly competitive market all firms receive the same price for each good sold (P=$20).

What will be the profit maximising level of output for this firm? Calculate the firm’s level of profit at this level of output. Complete Question 2, Anderton, p.287.

$20

Profit maximisation: the MR=MC rule }  Provided a firm can make additional profit by producing

an extra unit of output, it will carry on expanding production.

}  However, the firm will stop extra production when the extra unit yields a loss (i.e. where marginal profit moves from positive to negative).

}  Note that cost includes an allowance for normal profit and therefore the firm will produce until marginal profit is equal to zero.

}  Economic theory thus predicts that profits will be maximised at the output level where marginal cost equals marginal revenue.

Cost and revenue curves

Cost and revenue

Price

0 Output

0 Output

TR

MR

MC

TC Profit is maximised at the level of output where the difference between total revenue and total cost is at its greatest, at 0C.

This is the point where marginal cost equals marginal revenue.

The firm will make a loss if it produces between 0 and B.

B is the break-even point.

Between B and D the firm is in profit.

Profit is maximised at C where the difference between TR and TC is at a maximum.

If the firms produces more than D it will start making a loss again.

D is the maximum level of output that the firm can produce without making a loss.

D is the sales maximisation point subject to the constraint that the firm should not make a loss.

CB D

C


Cost and revenue

Price

0 Output

0 Output

TR

MR

MC

TC Looking at the MR and MC curves, the profit maximising level of output, 0C, is the point where MC=MR.

If the firm produces an extra unit of output above 0C, then the marginal cost of production is above the marginal revenue received from selling the extra unit.

The firm will make a loss on that extra unit and total profit will fall.

The firm will expand production if marginal revenue is above marginal cost. The firm will reduce output is marginal revenue is below marginal cost.

CB D

C


Cost and revenue

Price

0 Output

0 Output

TR

MR

MC

TC

CB D

A C

Note that MC also equals MR at point A. It is not always the case that the MC curve will start above the MR, however, if it does, then the first intersection point of the two curves (when MC is falling) is not the profit maximising point.

The MC=MR rule is therefore a necessary but not sufficient condition for profit maximisation. MC must also be rising as well.

Complete Question 3, Anderton, p.287.

Shifts in cost curves C

osts

and

re

venu

e ($

)

MC1

Output

MR P1

Suppose the price of raw materials increases, increasing the cost of production.

This will mean that marginal cost of production will be higher at every level of output.

The MC curve will shift up from MC1 to MC2.

The profit maximising level of output will fall from 0Q1 to 0Q2.

Hence a rise in costs will lead to a fall in the profit maximising level of output.

MC2

Q1 Q2 0

Shifts in revenue curves C

osts

and

re

venu

e ($

)

MC

Output

MR1 P1

Suppose consumers were prepared to pay higher prices for a product because their incomes had increased.

This will push the marginal revenue curve upwards.

The profit maximising level of output will then rise from 0Q1 to 0Q2.

Q2 Q1 0

MR2 P2


Profit maximisation – imperfect competition

}  The MC=MR rule also applies to imperfectly competitive markets.

Cos

ts a

nd

reve

nue

($)

MC

Output

MR

P1

If a firm produces up to the point where the cost of making the last unit is just covered by the revenue gained from selling it, then the profit margin will have fallen to zero and total profits will be at their greatest.

A firm producing output to the left of Q is sacrificing potential profit. It can raise total profit by increasing output.

A firm producing to the right of Q is making a loss on each successive unit, which will lower the total profit. It would be better off cutting output back to Q where MC=MR.

Q2 Q 0

Profit max output MC=MR

MR>MC

MC>MR

Why some firms do not operate at the profit maximising level of output }  In practice, it may be difficult to identify this output. }  Short-term profit maximising may not be in the long term

interest of the company since: }  firms with large market shares may wish to avoid the attention

of the government watch dog bodies; }  large abnormal profits may attract new entrants into the

industry; }  high profits may damage the relationship between the firm and

its stakeholders, such as consumers and the company workforce;

}  profit maximisation may not main objective of the business; }  high profits might trigger action by the firm’s rivals and it could

become the target for a take-over bid.

Objectives of firms

Who controls a firm’s decisions? The control of a firm is likely to lie with one or more of a firms stakeholders. }  The owners or shareholders }  Directors and managers }  The workers }  The state }  The consumer

}  pressure groups }  consumer sovereignty

Profit maximisation C

osts

and

re

venu

e ($

)

MC

Output

Profit maximisation will occur where MC=MR.

Profit is the difference between AC and AR and represented by the shaded area.

The profit maximising level of output is therefore Q1.

Q1 0

P1

D=AR

AC

Profit max output MC=MR

MR

Profit maximisation }  The standard assumption made by economists is that

firms will seek to maximise their profits. }  Neo classical economics assumes that it is short run

profits that a firm maximises. }  Neo-Keynsian economists believe that firms maximise

their long run profit rather than their short run profit.

Sales revenue maximisation C

osts

and

re

venu

e ($

)

MC

Output

Sales revenue maximisation occurs where MR=0.

If the firm sold one more unit of output beyond MR=0, the negative marginal revenue would lead to a reduction in total sales revenue.

The sales revenue maximising level of output is therefore Q2.

There may still be abnormal profit at this level of output if total revenue is higher than total cost.

Q2 0

P1

D=AR

MR

AC

Sales revenue maximisation: MR=0

Q1

P2

Sales revenue maximisation }  A firm may be prepared to accept a lower price and

produce above the profit-maximising level of output in order to increase its market share in a growing market. This is penetration pricing policy.

}  Another reason why firms sales revenue maximisation might be chosen in a large firm is that management salaries might be linked to the value of sales.

}  Shareholders, on the other hand, might be more interested in profit.

}  The solution to this conflict of interests might be to offer management some shares as a bonus or link their salaries to profits.

Sales revenue maximisation }  However, it is also in the interests of the managers for the

firm to be profitable. }  Managers must be seen as efficient enough to justify their

salaries. A shareholders’ revolt is always a possibility. }  Also, there is always the threat of takeover or bankruptcy

leading to the loss of their jobs. }  Therefore, managers must make enough profit to satisfy

the demands of their shareholders. This is know as profit satisficing.

}  However, once a satisfactory level of profits have been made, managers are free to maximise their own rewards in the company.

Sales maximisation C

osts

and

re

venu

e ($

)

MC

Output Q2 0

P1

D=AR

MR

AC Sales maximisation: AR=AC

Q1

P2

Q3

P3

Sales maximisation occurs where AR=AC (break-even).

An additional unit sold beyond this point would cost the firm more than the revenue it would receive.

Hence, the firm would be making a loss which would eventually lead to bankruptcy.

Therefore, output Q3 is the most the firm can sell without making a loss.

Sales maximisation }  This objective maximises the volume of sales rather than

the sales revenue. }  In sales maximisation, the firm would increase output up

to break-even output. }  Again, a firm may be prepared to accept a lower price and

produce above the profit-maximising level of output in order to increase its market share or to break into new markets (penetration pricing strategy).

Loss-making behaviour }  Loss-making behaviour is when firms operate beyond

their break-even level of output. }  The only situation in which loss-making behaviour is

possible is where the firm could use the profit from other activities to cover the losses using the principle of cross-subsidisation.

}  For example, in the public sector, a state-owned firm there could be social objectives lying behind price and output decisions.

}  The company might be instructed to keep prices down. Any resulting losses would be paid for from government tax revenue.

Loss-making behaviour }  In the private sector, the firm would have to be part of a

diversified grouping where cross-subsidisation is being practiced.

}  Deliberately cutting the price to reduce profit might be a strategy to deter new firms from entering the market.

}  It may also be used to force out existing competitors and may result in a price war within the industry.

}  This is called predator or destroyer pricing.

Satisficing profits }  This behaviour occurs when a firm aims to make a

reasonable level of profits, sufficient to satisfy the shareholders but also to keep the other stake-holding groups happy, such as the workforce and, of course, consumers.

}  There are a number of stakeholders in the firm, each with their own objective that may change over time.

}  Firms may therefore choose to sacrifice some short-term profits to satisfy the expectations of stakeholders.

Stakeholder objectives }  Workers will expect to see improvements in working

conditions which may raise costs. }  Shareholders will expect the firm to make profits. As a

result, dividend payments to shareholders may have to be increased.

}  Consumers will expect a minimum level of quality for the price they pay for the goods purchased.

}  The government demands that laws be obeyed and taxes paid.

}  Local environmentalists will expect the company to be socially responsibly and may be able to exert enough pressure to prevent gross over-pollution.


Other objectives }  Consumer co-operatives aim to help consumers. }  Worker co-operatives are often motivated by a desire to

maintain jobs or to produce a particular product, such as health foods.

Whilst it is simplistic to argue that all firms aim to maximise profit, it is not unreasonable to make the assumption that, in general, firms are profit maximisers.

Conclusion

Theory of the firm

Reasons for the survival of small firms

}  The size of the market – there are economic activities where the size of the market is too small to support large firms.

}  Market niches – small firms can fill in market niches left by big ones.

}  Barriers to entry may be low – It may be easy and relatively inexpensive for a small firm to set up and establish itself in the market.

}  Local, flexible and personal service – small firms such as solicitors, accountants, hairdressers, dentists, hardware stores and small shops are able to offer customers personal attention for which they will pay a higher price.



}  Future potential – small firms may simply be the big firms of tomorrow. Although the number of small firms is high, it is misleading because of the fact that they have a very high ‘death rate’.

}  Lack of capital to finance business expansion – there are particular obstacles to the growth of small firms, which includes access to borrowed capital.

}  Business objectives – the entrepreneur may not want the firm to get bigger because extra profit is not the only objective or because expansion may involve a loss of control over running the business.


}  Sub-contracting and outsourcing – it is sometimes cheaper for large firms to contract out some of the peripheral tasks such as design, data processing and marketing to specialist small firms.

}  Suppliers of small quantities of components – manufacturing firms may buy in components from small suppliers producing for a range of companies, because it is cheaper than the large firm trying to supply small quantities itself.


}  New technology – the increased access to technology through personal computers, the internet and mobile phones has reduced the optimum size of the business unit and made small businesses more efficient and therefore competitive with the larger ones.

}  New products – in the field of computing and technology, it is often the small firms which pioneer new products. This innovation is illustrated by the volume of computer software produced by people who previously worked for large organisations.

}  Lower costs of production – A small firm may be able to pay relatively low wages in informal labour markets. Also, owners of small businesses can work exceptionally long hours at effective rates of pay which they would find totally unacceptable in a normal job.

}  Lower rate of return – A small business owner such as a corner shop sole proprietor, may be prepared to accept a much lower rate of return on capital employed than would a large company.

‘SMEs in Africa and Asia’, Bamford 2nd Edition, p.93-94


The growth of firms }  Firms may grow in two ways:

}  by internal growth }  by external growth through merger, amalgamation or

takeover.

Internal growth

}  Internal growth simply refers to firms increasing their output, e.g. through increased investment or increased labour force.

External growth }  A merger or amalgamation is the joining together of two or

more firms under common ownership. }  The boards of directors of the two companies, with the

agreement of the shareholders, agree to merge their two companies together.

}  A takeover implies that one company wishes to buy another company.

}  A hostile takeover is when the board of directors recommends to its shareholders to reject the terms of the bid.

}  A takeover battle is then likely to ensue. A company must get promises to sell at the offer price of just over 50 per cent of the shares to win and take control.

}  http://www.youtube.com/watch?v=1w2hWzDKoYc

Types of merger }  A horizontal merger is between two firms in the same

industry at the stage of production, e.g. the merger of two car manufacturers.

}  A vertical merger is a merger between two firms at different stages of production. }  Forward integration involves a supplier merging with one of its

buyers, such as a car manufacturer buying a car dealership. }  Backward integration involves the purchaser buying one of its

suppliers, such as a car manufacturer buying a tyre company.

}  A conglomerate merger is the merging of two firms with no common interest, e.g. a food company buying a clothing chain.

Horizontal integration

}  When one firm merges with or takes over another one in the same industry at the same stage of production. Primary

Secondary

Tertiary

Confectionary Manufacturer B

Confectionery Manufacturer A

Benefits of horizontal integration

}  The merger reduces the number of competitors in the industry

}  There are opportunities for economies of scale }  The combined business will have a bigger share of the total

market

Forward vertical integration

Primary

Secondary

Tertiary

Coffee-growing cooperative

Coffee roasting plant

Acquisition takes place towards the market

Benefits of forward vertical integration

For example, a car manufacturer takes over a car retailing business.

}  The merger gives an assured outlet for their product.

}  The profit margin made by the retailer is absorbed by the expanded business

}  The retailer could be prevented from selling competing makes of car.

}  Information about customer needs and preferences can now be obtained directly by the manufacturer.

Primary

Secondary

Tertiary Retail Stores

Manufacturer

Backward vertical integration Acquisition takes place towards the source

Benefits of backward vertical integration

For example, a car manufacturer takes over a firm supplying car body panels.

}  The merger gives an assured supply of important components.

}  The profit margin of the supplier is absorbed by the expanded business.

}  The supplier could be prevented from supplying other manufacturers.

}  Costs of components and supplies for the manufacturer could be controlled.

Conglomerate integration

}  When one firm merges with or takes over a firm in a completely different industry.

Soft drink Manufacturer

Clothing Manufacturer

Benefits of conglomerate integration

}  The business now has activities in more than one industry. This means that the business has diversified its activities, which reduces the risk of making a loss. For example:

�  Ideas and expertise could be exchanged between the businesses, even though they operate in different industries.

Newspaper Computer manufacturer

Toyota Lateral Integration

Horizontal Integration

Backward Vertical

Integration

Forward Vertical

Integration Conglomerate

Integration

Steel Factory

Ice Cream

DAF Trucks

Car Dealership

Honda

Summary – types of external growth

Reasons for growth 1.  The desire to achieve a reduction in ATC over time

through the benefits of economies of scale 2.  To achieve a bigger market share, which would boost

sales revenue and possibly profits 3.  To diversify the product range 4.  To capture the resources of another business

1. The desire to achieve a reduction in ATC over time through the benefits of economies of scale

}  A larger company is able to exploit economies of scale more fully.

}  For example, the merger of two medium sized car manufacturers is likely to result in potential economies in all fields, from production and marketing to finance.

}  Vertical and conglomerate integration is less likely to yield economies of scale because there are unlikely to be any technical economies.

}  However, there may be some marketing economies and financial economies.

2. To achieve a bigger market share, which would boost sales revenue and possibly profits

}  A larger company may be more able to control its markets.

}  It may therefore reduce competition in the market place in order to be better able to exploit the market.

http://www.bbc.co.uk/news/business-15494135

http://www.thelocal.se/37380/20111116/#

3. To diversify the product range

}  A larger company is able to reduce risk. }  Many conglomerate companies have grown for this

reason. }  Some markets are fragile. They are subject to large

changes in demand when economies go into boom or recession.

}  For example, a steel manufacturer will do exceptionally well in a boom, but will be hard hit in a recession.

}  It may therefore decide to diversify by buying a company with a product which does not have a cyclical demand pattern, like a supermarket chain.

4. To capture the resources of another business

}  Sometimes, firms may realise that resources are being underutilised in another firm and that the real value of the firm is currently above the accounting valuation.

}  The resulting mergers and takeovers can lead to the firm being brought back into profit or being broken up.

}  This is because the sum of the parts sold separately is greater then the current valuation of the whole enterprise.

}  It is sometimes called ‘asset stripping’ and the cash may be used to improve the core business.

1.  ‘Competition up in the air’, Bamford 2nd Edition, p.95. 2.  ‘Pharmaceutical industry mergers beat recession’, Bamford 2nd Edition, p. 96.

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