A2 Microeconomics Course Companion

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A2 Microeconomics Course Companion

  1. 1. A2 EconomicsMicroeconomics Course Companion 2009
  2. 2. 2Introduction to the A2 Microeconomics Study CompanionWelcome to this 2008-09 edition of the Tutor2u A2 microeconomics study companion. The editionhas been revised throughout and seeks to provide a comprehensive coverage of some of the keyideas in the A2 business economics courses together with coverage of environmental market failureissues and aspects of labour market economics.The digital version of this study companion contains many links to selected online resources such asrecent news articles from recommended newspapers and magazine. And also to the Tutor2ueconomics blog so that when you click on such a link, you will be guaranteed to be taken to the latestblog features written after this study companion was completed.This study companion is designed as a complement to your studies in A2 Economics and should notbe regarded as a substitute for taking effective notes in your lessons. Points raised and issuescovered in class analysis and discussion invariably go beyond the confines of this guide. And withEconomics being the subject that it is, events and new economic policy debates will inevitablysurface over the next twelve months that take you into new and exciting territory.Economics is a dynamic subject, the issues change from day to day and there is a wealth ofcomment and analysis in the broadsheet newspapers, magazines and journals that you can delveinto. The more reading you manage on the main issues of the day the wider will be your appreciationof the theory and practice of economics.Further resources including online tests and revision notes are available from the Tutor2u virtuallearning environment (VLE) at http://vle.tutor2u.net Check to see if your school or college has asubscription to this resource and EconoMax Tutor2u‘s digital magazine for Economics.I acknowledge the help given in the preparation of this study companion by my own students and Ialso acknowledge some of the ideas and arguments put forward in articles written by Bob Nutter, JimRiley, Liz Veal and Mark Johnston – some of my fellow writers for the EconoMax digital magazinefrom which a small number of articles have been adapted as mini case studies.Good luck with your studiesGeoff RileyThis study companion follows the AQA syllabus and chapters are grouped into five main sectors: 1. The Firm: Objectives, Costs and Revenues 2. Competitive Markets 3. Concentrated Markets 4. The Labour Market 5. Government Intervention in the Market http://www.tutor2u.net/blog/index.php/economics/
  3. 3. 3Contents1. Production in the Short and the Long Run .................................................................................. 42. How can we calculate the costs of a firm? .................................................................................. 83. Long Run Costs: Economies and Diseconomies of Scale ........................................................ 134. Business Revenues ................................................................................................................... 235. Profits ......................................................................................................................................... 266. What Objectives Do Firms Have? ............................................................................................. 347. Divorce between Ownership and Control .................................................................................. 388. Technological Change, Costs and Supply in the Long-run ....................................................... 429. The Growth of Firms .................................................................................................................. 4510. Perfect Competition ................................................................................................................... 5111. Monopolistic Competition........................................................................................................... 5912. The Model of Monopoly ............................................................................................................. 6213. Barriers to Entry and Exit in Markets ......................................................................................... 6514. Price Discrimination ................................................................................................................... 6915. Monopoly and Economic Efficiency ........................................................................................... 7616. Collusive and Non-Collusive Oligopoly ..................................................................................... 8417. Oligopoly and Game Theory ...................................................................................................... 9018. Contestable Markets .................................................................................................................. 9719. Monopsony Power in Product Markets.................................................................................... 10120. Consumer and Producer Surplus ............................................................................................ 10321. Price Takers and Price Makers – Pricing Power ..................................................................... 10622. Competition Policy and Regulation.......................................................................................... 11123. Privatisation and Deregulation ................................................................................................. 11624. The Labour Market................................................................................................................... 12425. Monopsony in the Labour Market ............................................................................................ 13726. Discrimination in the Labour Market ........................................................................................ 13927. Trade Unions in the Labour Market ......................................................................................... 14228. The Distribution of Income and Wealth ................................................................................... 14629. Market Failure - Externalities ................................................................................................... 15330. Carbon Emissions Trading and the Stern Review .................................................................. 15931. Cost Benefit Analysis ............................................................................................................... 165 http://www.tutor2u.net/blog/index.php/economics/
  4. 4. 4 1. Production in the Short and the Long RunWe take it for granted that goods and services will be available for us to buy as and when we needthem. But production and supplying to the market is often a complicated business.Production FunctionsThe production function elates the quantity of factor inputs to the volume of outputs that result.We make use of three measures of production and productivity. o Total product means total output. In most manufacturing industries such as motor vehicles, motor homes and DVD players, it is straightforward to measure production from labour and capital inputs. But in many service or knowledge-based industries, where the output is less ―tangible‖ or perhaps ‗weightless‘ we find it harder to measure productivity. o Average product measures output per-worker-employed or output-per-unit of capital. o Marginal product is the change in output from increasing the number of workers used by one person, or by adding one more machine to the production process in the short run.The length of time required for the long run varies from sector to sector. In the nuclear power industry for example, it can take many years to commission new nuclear power plant and capacity. This is something the UK government has to consider as it reviews our future sources of energy.Short Run Production FunctionThe short run is a time period where at least one factor of production is in fixed supply - itcannot be changed. We normally assume that the quantity of plant and machinery is fixed and thatproduction can be altered through changing variable inputs such as labour, raw materials andenergy.The time periods used in economics must differ from one industry to another. The short-run for theelectricity generation industry or telecommunications differs from magazine publishing and localsandwich bars. If you are starting out in business this autumn with a new venture selling sandwichesand coffees to office workers, how long is your short run? And how long is your long run? (!!). The http://www.tutor2u.net/blog/index.php/economics/
  5. 5. 5long run could be as short as a few days – enough time to lease a new van and a sandwich makingmachine!Diminishing ReturnsIn the short run, the law of diminishing returns states that as we add more units of a variable inputto fixed amounts of land and capital, the change in total output will at first rise and then fall.Diminishing returns to labour occurs when marginal product of labour starts to fall. This means thattotal output will be increasing at a decreasing rate.What happens to marginal product is linked directly to the productivity of each extra worker. Beyonda certain point new workers will not have as much capital to work with so – it becomes dilutedamong a larger workforce. As a result, the marginal productivity tends to fall – this is the principle ofdiminishing returns. An example is shown below. We assume that there is a fixed supply of capital(20 units) available in the production process to which extra units of labour are added. Initially the marginal product is rising – e.g. the 4th worker adds 26 to output and the 5th worker adds 28. It peaks when the sixth worked is employed when the marginal product is 29. Marginal product then starts to fall. At this point production demonstrates diminishing returns.The Law of Diminishing Returns Capital Input Labour Input Total Output Marginal Product Average Product of Labour 20 1 5 5 20 2 16 11 8 20 3 30 14 10 20 4 56 26 14 20 5 85 28 17 20 6 114 29 19 20 7 140 26 20 20 8 160 20 20 20 9 171 11 19 20 10 180 9 18 http://www.tutor2u.net/blog/index.php/economics/
  6. 6. 6 Total Output Slope of the curve gives the (Q) (Q) marginal product of labour Diminishing returns are apparent here – total output is rising but at a decreasing rate Units of Labour Employed (L)Average product rises as long as the marginal product is greater than the average – for examplewhen the seventh worker is added the marginal gain in output is 26 and this drags the average upfrom 19 to 20 units. Once marginal product is below the average as it is with the ninth workeremployed (where marginal product is only 11) then the average must decline.This is an important example of the relationship between marginal and average values that we willreturn to later on when studying costs and revenues.Criticisms of the Law of Diminishing ReturnsHow realistic is this assumption of diminishing returns? Surely ambitious and successful businesseswill do their level best to avoid such a problem emerging?It is now widely recognised that the effects of globalisation and the ability of trans-nationalcorporations to source their inputs from more than one country and engage in transfers ofbusiness technology, makes diminishing returns less relevant. Many businesses are multi-plantmeaning that they operate factories in different locations – can switch output to meet changingdemand.A rise in productivity and the production functionIn the following diagram we trace the effects of a rise in the productivity of the labour force at eachlevel of employment. If average productivity rises, then the production curve shifts upwards. Diminishing returns are still assumed to exist in this diagram as shown by the shape of the production curve, but total output is higher for each number of people employed. If productivity rises, for a given level of wages, this will cause a fall in the unit labour costs of production.Other things remaining the same, there is an inverse relationship between productivity and cost.This is an important relationship for businesses to understand when they are seeking efficiency gainsas a means of boosting profits.Long Run Production - Returns to ScaleIn the long run, all factors of production are variable. How the output of a business responds to achange in factor inputs is called returns to scale.Numerical example of long run returns to scale http://www.tutor2u.net/blog/index.php/economics/
  7. 7. 7Units of Units of Total % Change in % Change in Returns to ScaleCapital Labour Output Inputs Output20 150 300040 300 7500 100 150 Increasing60 450 12000 50 60 Increasing80 600 16000 33 33 Constant100 750 18000 25 13 Decreasing In our example when we double the factor inputs from (150L + 20K) to (300L + 40K) then the percentage change in output is 150% - there are increasing returns to scale. In contrast, when the scale of production is changed from (600L + 80K0 to (750L + 100K) then the percentage change in output (13%) is less than the change in inputs (25%) implying a situation of decreasing returns to scale. Increasing returns to scale occur when the % change in output > % change in inputs Decreasing returns to scale occur when the % change in output < % change in inputs Constant returns to scale occur when the % change in output = % change in inputsThe nature of the returns to scale affects the shape of a business‘s long run average cost curve. http://www.tutor2u.net/blog/index.php/economics/
  8. 8. 8 2. How can we calculate the costs of a firm?In this chapter we look at production costs. In the short run, because at least one factor ofproduction is fixed, output can be increased only by adding more variable factors.Fixed costsFixed costs do not vary directly with the level of outputExamples of fixed costs include the rental costs of buildings; the costs of leasing or purchasingcapital equipment such as plant and machinery; the annual business rate charged by localauthorities; the costs of full-time contracted salaried staff; the costs of meeting interest payments onloans; the depreciation of fixed capital (due solely to age) and also the costs of business insurance.Fixed costs are the overhead costs of a business.Key points:  Total fixed costs (TFC) these remain constant as output increases  Average fixed cost (AFC) = total fixed costs divided by outputAverage fixed costs must fall continuously as output increases because total fixed costs arebeing spread over a higher level of production. In industries where the ratio of fixed to variable costsis extremely high, there is great scope for a business to exploit lower fixed costs per unit if it canproduce at a big enough size. Consider the Sony PS3 or the new iPhone where the fixed costs ofdeveloping the product are enormous, but these costs can be divided by millions of individual unitssold across the world. Successful product launches and huge volume sales can make a hugedifference to the average total costs of production.Please note! A change in fixed costs has no effect on marginal costs. Marginal costs relate only tovariable costs!Variable CostsVariable costs are costs that vary directly with output.Examples of variable costs include the costs of raw materials and components, the wages of part-time staff or employees paid by the hour, the costs of electricity and gas and the depreciation ofcapital inputs due to wear and tear. Average variable cost (AVC) = total variable costs (TVC) /output(Q)Average Total Cost (ATC or AC) Average total cost is the cost per unit produced Average total cost (ATC) = total cost (TC) / output (Q)Marginal CostMarginal cost is the change in total costs from increasing output by one extra unit.The marginal cost of supplying an extra unit of output is linked with the marginal productivity oflabour. The law of diminishing returns implies that marginal cost will rise as output increases.Eventually, rising marginal cost will lead to a rise in average total cost. This happens when the rise inAVC is greater than the fall in AFC as output (Q) increases.A numerical example of short run costs is shown in the table below. Fixed costs are assumed to beconstant at £200. Variable costs increase as more output is produced. http://www.tutor2u.net/blog/index.php/economics/
  9. 9. 9 Output Total Fixed Total Variable Total Cost Average Cost Marginal Cost (Q) Costs (TFC) Costs (TVC) Per Unit (the change in total cost from a one unit change in output) (TC= TFC + (AC = TC/Q) TVC) 0 200 0 200 50 200 100 300 6 2 100 200 180 400 4 2 150 200 230 450 3 1 200 200 260 460 2.3 0.2 250 200 280 465 1.86 0.1 300 200 290 480 1.6 0.3 350 200 325 525 1.5 0.9 400 200 400 600 1.5 1.5 450 200 610 810 1.8 4.2 500 200 750 1050 2.1 4.8 In our example, average cost per unit is minimised at a range of output - 350 and 400 units. Thereafter, because the marginal cost of production exceeds the previous average, so the average cost rises (for example the marginal cost of each extra unit between 450 and 500 is 4.8 and this increase in output has the effect of raising the cost per unit from 1.8 to 2.1).An example of fixed and variable costs in equation formatIf for example, the short-run total costs of a firm are given by the formulaSRTC = $(10 000 + 5X2) where X is the level of output. The firm‘s total fixed costs are $10,000 The firm‘s average fixed costs are $10,000 / X If the level of output produced is 50 units, total costs will be $10,000 + $2,500 = $12,500The Shape of Short Run Cost CurvesWhen diminishing returns set in (beyond output Q1) the marginal cost curve starts to rise. Averagetotal cost continues to fall until output Q2 where the rise in average variable cost equates with the fallin average fixed cost. Output Q2 is the lowest point of the ATC curve for this business in the shortrun. This is known as the output of productive efficiency. http://www.tutor2u.net/blog/index.php/economics/
  10. 10. 10 If marginal cost is below average cost then average must be falling. Even if MC is rising, AC falls if MC <AC. For this reason, MC curve intersects the AC curve at the lowest point of the AC curve. Diminishing returns starts to occur when marginal cost starts to rise. Costs Marginal Cost (MC) Average Total Cost (ATC) Average Variable Cost (AVC) Average Fixed Cost (AFC) Q1 Q2 Output (Q)Key point: The marginal cost curve must intersect the average curves at their minimum levelsA change in variable costsA rise in the variable costs of production – perhaps due to a rise in oil and gas prices or a rise in thenational minimum wage - leads to an upward shift both in marginal and average total cost. The firm isnot able to supply as much output at the same price. The effect is that of an inward shift in the supplycurve of a business in a competitive market. http://www.tutor2u.net/blog/index.php/economics/
  11. 11. 11 Costs MC2 AC2 Marginal Cost (MC1) Average Total Cost (ATC1) Average Variable Cost (AVC1) AVC2 Output (Q)An increase in fixed costs has no effect on the variable costs of production. This means that only theaverage total cost curve shifts. There is no change on the marginal cost curve leading to no changein the profit maximising price and output of a business. The effects of an increase in the fixed oroverhead costs of a business are shown in the diagram below. Costs MC AC2 (after rise in fixed costs) AC1 Output (Q)Suggestions for background reading on changes in business costsCadbury‘s plans to increase prices (BBC news, February 2008)Dry cleaners facing rising costs (BBC news, June 2008)Grain prices are squeezing bakers (BBC news, April 2008) http://www.tutor2u.net/blog/index.php/economics/
  12. 12. 12Milk costs hit Stilton producers (BBC news, July 2007) http://www.tutor2u.net/blog/index.php/economics/
  13. 13. 13 3. Long Run Costs: Economies and Diseconomies of ScaleEconomies of Scale Economies of scale are the cost advantages from expanding the scale of production in the long run. The effect is to reduce average costs over a range of output. These lower costs represent an improvement in productive efficiency and can also give a business a competitive advantage in the market-place. They lead to lower prices and higher profits – a positive sum game for producers and consumers. We make no distinction between fixed and variable costs in the long run because all factors of production can be varied. As long as the long run average total cost (LRAC) is declining, economies of scale are being exploited. Long Run Output (Units) Total Costs (£s) Long Run Average Cost (£ per unit) 1000 12000 12 2000 20000 10 5000 45000 9 10000 80000 8 20000 144000 7.2 50000 330000 6.6 100000 640000 6.4 500000 3000000 6Returns to scale and costs in the long runThe table below shows how changes in the scale of production can, if increasing returns to scaleare exploited, lead to lower long run average costs. Factor Inputs Production Costs (K) (La) (L) (Q) (TC) (TC/Q) Capital Land Labour Output Total Cost Average CostScale A 5 3 4 100 3256 32.6Scale B 10 6 8 300 6512 21.7Scale C 15 9 12 500 9768 19.5Costs: Assume the cost of each unit of capital = £600, Land = £80 and Labour = £200Because the % change in output exceeds the % change in factor inputs used, then, although totalcosts rise, the average cost per unit falls as the business expands from scale A to B to C. http://www.tutor2u.net/blog/index.php/economics/
  14. 14. 14Increasing Returns to ScaleMuch of the new thinking in economics focuses on the increasing returns available to a companygrowing in size in the long run.An example of this is the computer software business. The overhead costs of developing newsoftware programs such as Microsoft Vista or computer games such as Halo 3 are huge - oftenrunning into hundreds of millions of dollars - but the marginal cost of producing one extra copy forsale is close to zero, perhaps just a few cents or pennies. If a company can establish itself in themarket in providing a piece of software, positive feedback from consumers will expand the installedcustomer base, raise demand and encourage the firm to increase production. Because the marginalcost is so low, the extra output reduces average costs creating economies of size.Lower costs normally mean higher profits and increasing financial returns for the shareholders. Whatis true for software developers is also important for telecoms companies, transport operators andmusic distributors. We find across so many different markets that a high percentage of costs are fixedthe higher is demand and output, the lower will be the average cost of production.Long Run Average Cost CurveThe LRAC curve (also known as the „envelope curve‟) is usually drawn on the assumption of theirbeing an infinite number of plant sizes – hence its smooth appearance in the next diagram below.The points of tangency between LRAC and SRAC curves do not occur at the minimum points of theSRAC curves except at the point where the minimum efficient scale (MES) is achieved.If LRAC is falling when output is increasing then the firm is experiencing economies of scale. Forexample a doubling of factor inputs might lead to a more than doubling of output.Conversely, When LRAC eventually starts to rise, the firm experiences diseconomies of scale, and,If LRAC is constant, then the firm is experiencing constant returns to scale Costs SRAC1 SRAC3 SRAC2 AC1 LRAC AC2 AC3 Q1 Q2 Q3 Output (Q) http://www.tutor2u.net/blog/index.php/economics/
  15. 15. 15There are many different types of economy of scale. Depending on the characteristics of an industryor market, some are more important than others.Internal economies of scale (IEoS)Internal economies of scale come from the long term growth of the firm itself. Examples include: 1. Technical economies of scale: (these relate to aspects of the production process itself): a. Expensive capital inputs: Large-scale businesses can afford to invest in specialist capital machinery. For example, a supermarket might invest in database technology that improves stock control and reduces transportation and distribution costs. Highly expensive fixed units of capital are common in nearly every mass manufacturing production process. b. Specialization of the workforce: Larger firms can split the production processes into separate tasks to boost productivity. Examples include the use of division of labour in the mass production of motor vehicles and in manufacturing electronic products. c. The law of increased dimensions (or the “container principle”) This is linked to the cubic law where doubling the height and width of a tanker or building leads to a more than proportionate increase in the cubic capacity – the application of this law opens up the possibility of scale economies in distribution and freight industries and also in travel and leisure sectors with the emergence of super-cruisers such as P&O‘s Ventura. Consider the new generation of super-tankers and the development of enormous passenger aircraft such as the Airbus 280 which is capable of carrying well over 500 passengers on long haul flights. The law of increased dimensions is also important in the energy sectors and in industries such as office rental and warehousing. Amazon UK for example has invested in several huge warehouses at its central distribution points – capable of storing hundreds of thousands of items. d. Learning by doing: There is growing evidence that industries learn-by-doing! The average costs of production decline in real terms as a result of production experience as businesses cut waste and find the most productive means of producing output on a bigger scale. Evidence across a wide range of industries into so-called ―progress ratios‖, or ―experience curves‖ or ―learning curve effects‖, indicate that unit manufacturing costs typically fall by between 70% and 90% with each doubling of cumulative output. Businesses that expand their scale can achieve significant learning economies of scale. http://www.tutor2u.net/blog/index.php/economics/
  16. 16. 16 Cost(Per unit of output) Economies of Scale A B LRAC1 Learning C LRAC2 economies Output2. Monopsony power: A large firm can purchase its factor inputs in bulk at discounted prices if it has monopsony (buying) power. A good example would be the ability of the electricity generators to negotiate lower prices when finalizing coal and gas supply contracts. The national food retailers have monopsony power when purchasing their supplies from farmers and wine growers and in completing supply contracts from food processing businesses. Other controversial examples of the use of monopsony power include the prices paid by coffee roasters and other middle men to coffee producers in some of the poorest parts of the world.3. Managerial economies of scale: This is a form of division of labour where firms can employ specialists to supervise production systems. Better management; increased investment in human resources and the use of specialist equipment, such as networked computers can improve communication, raise productivity and thereby reduce unit costs.4. Financial economies of scale: Larger firms are usually rated by the financial markets to be more „credit worthy‟ and have access to credit with favourable rates of borrowing. In contrast, smaller firms often pay higher rates of interest on overdrafts and loans. Businesses quoted on the stock market can normally raise new financial capital more cheaply through the sale of equities to the capital market.5. Network economies of scale: (Please note: This type of economy of scale is linked more to the growth of demand for a product – but it is still worth understanding and applying.) There is growing interest in the concept of a network economy. Some networks and services have huge potential for economies of scale. That is, as they are more widely used (or adopted), they become more valuable to the business that provides them. We can identify networks economies in areas such as online auctions and air transport networks. The marginal cost of adding one more user to the network is close to zero, but the resulting financial benefits may be huge because each new user to the network can then interact, trade with all of the existing members or parts of the network. The rapid expansion of e-commerce is a great example of the exploitation of network economies of scale. EBay is a classic example of exploiting network economies of scale as part of its operations. http://www.tutor2u.net/blog/index.php/economics/
  17. 17. 17 The container principle at work!Economies of scale – the effects on price, output and profits for a profit maximizing firmScale economies allow a supplier to move from SRAC1 to SRAC2. A profit maximising producer willproduce at a higher output (Q2) and charge a lower price (P2) as a result – but the total abnormalprofit is also much higher (compare the two shaded regions).Both consumer and producer surplus (welfare) has increased – there has been an improvement ineconomic welfare and economic efficiency – the key is whether cost savings are passed ontoconsumers! MC1 Costs Profit at Price P1 Profit at Price P2 P1 SRAC1 SRAC2 P2 MC2 AR (Demand) MR Q1 Q2 Output (Q)External economies of scale (EEoS)External economies of scale occur outside of a firm but within an industry. For exampleinvestment in a better transportation network servicing an industry will resulting in a decrease in http://www.tutor2u.net/blog/index.php/economics/
  18. 18. 18costs for a company working within that industry, thus external economies of scale have beenachieved. Another example is the development of research and development facilities in localuniversities that several businesses in an area can benefit from. Likewise, the relocation ofcomponent suppliers and other support businesses close to the centre of manufacturing are alsoan external cost saving.Agglomeration economies may also result resulting from the clustering of similar businesses in adistinct geographical location be it software businesses in Silicon Valley or investment banks in theCity of London.Economies of Scale – The Importance of Market DemandThe market structure of an industry is affected by the extent of economies of scale available toindividual suppliers and by the total size of market demand. In many industries, it is possible forsmaller firms to make a profit because the cost disadvantages they face are relatively small. Orbecause product differentiation allows a business to charge a price premium to consumers whichmore than covers their higher costs.A good example is the retail market for furniture. The industry has some major players in each of itsdifferent segments (e.g. flat-pack and designer furniture) including the Swedish giant IKEA. However,much of the market is taken by smaller-scale suppliers with consumers willing to pay higher prices forbespoke furniture owing to the low price elasticity of demand for high-quality, hand crafted furnitureproducts. Small-scale manufacturers can therefore extract the consumer surplus that is presentwhen demand is estimated to have a low elasticity of demand.Economies of ScopeThese are different from economies of scale! Economies of scope occur where it is cheaper toproduce a range of products rather than specialize in just a handful of products. And they can beexploited when a business owns a resource that can be used more than once in different ways!For example, in the increasingly competitive world of postal services and business logistics, the mainservice providers such as Royal Mail, UK Mail, Deutsche Post and the international parcel carriersincluding TNT, UPS, and FedEx are broadening the range of their services and making more betteruse of their existing collection, sorting and distribution networks to reduce costs and earn higherprofits from higher-profit-margin and fast growing markets.A company‘s management structure, administration systems and marketing departments arecapable of carrying out these functions for more than one product.Expanding the product range to exploit the value of existing brands is a good way of exploitingeconomies of scope. Perhaps a good example of ―brand extension‖ is the Easy Group under thecontrol of Stelios where the distinctive Easy Group business model has been applied (with varyingdegrees of success) to a wide range of markets – easy Pizza, easy Cinema, easy Car rental, easyBus and easy Hotel to name just a handful! Procter and Gamble is the largest consumer householdproducts maker in the world. Its brands include Crest, Duracell, Gillette, Pantene, and Tide, to namejust a few. Twenty four of its brands make over $1 billion in sales annually.Another example of an economy of scope might be a restaurant that has catering facilities and usesit for multiple occasions – as a coffee shop during the day and as a supper-bar and jazz room in theevenings. Or a computing business can use its network and databases for many different uses.Case Study: Investment in Sports GroundsHotels are a hot topic at sports venues. The owners of these venues are looking for ways to makebetter return on their assets. The solution is to explore new business opportunities, invest inextensive modernisation and spend cash on large-scale redevelopment schemes. http://www.tutor2u.net/blog/index.php/economics/
  19. 19. 19Capacity utilisation is an important challenge facing a sporting venue. There are only so manycricket matches, grand prix races or rugby games that draw spectators.By adding purpose-built conference, banqueting and leisure facilities, sports venues can tap into adifferent customer base. A hotel facility can attract demand from businesses looking for corporatehospitality and conferences. Having a hotel also allows a venue to access consumer spending onshort breaks – one of the fastest growing segments of the leisure industry. Most of the plannedhotels will be branded (e.g. Holiday Inn, Marriott) which allows the venue to benefit from a trustedhotel name and gets access to established distribution channels. Source: Business CafeMinimum Efficient Scale (MES)The minimum efficient scale (MES) is the scale of production where the internal economies ofscale have been fully exploited. The MES corresponds to the lowest point on the long runaverage cost curve and is also known as an output range over which a business achievesproductive efficiency.The MES is not a single output level – more likely we describe the minimum efficient scale ascomprising a range of outputs where the firm achieves constant returns to scale and has reachedthe lowest feasible cost per unit. Costs Revenues LRAC Increasing return to scale – economies of Decreasing returns – scale - falling LRAC diseconomies of scale MES Q2 Output (Q)The MES depends on the nature of costs of production in a specific sector or industry. 1. In industries where the ratio of fixed to variable costs is high, there is plenty of scope for reducing unit cost by increasing the scale of output. This is likely to result in a concentrated market structure (e.g. an oligopoly, a duopoly or a monopoly) – indeed economies of scale may act as a barrier to entry because existing firms have achieved cost advantages and they then can force prices down in the event of new businesses coming in! 2. In contrast, there might be only limited opportunities for scale economies such that the MES turns out to be a small % of market demand. It is likely that the market will be competitive with many suppliers able to achieve the MES. An example might be a large number of hotels in a city centre or a cluster of restaurants in a town. Much depends on how we define the market! http://www.tutor2u.net/blog/index.php/economics/
  20. 20. 20 3. With a natural monopoly, the long run average cost curve continues to fall over a huge range of output, suggesting that there may be room for perhaps one or two suppliers to fully exploit all of the available economies of scale when meeting market demand.Diseconomies of scaleDiseconomies are the result of decreasing returns to scale.The potential diseconomies of scale a firm may experience relate to: 1. Control – monitoring the productivity and the quality of output from thousands of employees in big corporations is imperfect and costly – this links to the concept of the principal-agent problem – how best can managers assess the performance of their workforce when each of the stakeholders may have a different objective or motivation which can lead to stakeholder conflict? 2. Co-ordination - it can be difficult to co-ordinate complicated production processes across several plants in different locations and countries. Achieving efficient flows of information in large businesses is expensive as is the cost of managing supply contracts with hundreds of suppliers at different points of an industry‘s supply chain. 3. Co-operation - workers in large firms may develop a sense of alienation and loss of morale. If they do not consider themselves to be an integral part of the business, their productivity may fall leading to wastage of factor inputs and higher costs. Traditionally this has been seen as a problem experienced by the larger state sector businesses, examples being the Royal Mail and the Firefighters, the result being a poor and costly industrial relations performance. However, the problem is not concentrated solely in such industries. A good recent example of a bitter industrial relations dispute was between Gate Gourmet and its workers.Avoiding diseconomies of scaleA number of economists are skeptical about diseconomies of scale. They believe that propermanagement techniques and appropriate incentives can do much to reduce the risk of industrialstrife. Here are three of the reasons to doubt the persistence of diseconomies of scale: 1. Developments in human resource management (HRM). HRM is a horrible phrase to describe improvements that a business might make to procedures involving worker recruitment, training, promotion, retention and support of faculty and staff. This becomes critical to a business when the skilled workers it needs are in short supply. Recruitment and retention of the most productive and effective employees makes a sizeable difference to corporate performance in the long run. 2. Performance related pay schemes (PRP) can provide financial incentives for the workforce leading to an improvement in industrial relations and higher productivity. Another aim of PRP is for businesses to reward and hang onto their most efficient workers. The John Lewis Partnership is often cited as an example of how a business can empower its employees by giving them a stake in the financial success of the organization. 3. Increasingly companies are engaging in out-sourcing of manufacturing and distribution as they seek to supply to ever-distant markets. Out-sourcing is a tried and tested way of reducing costs whilst retaining control over production although there may be a price to pay in terms of the impact on the job security of workers whose functions might be outsourced overseas.Case Study: Amazon – Economies of Scale and Scope http://www.tutor2u.net/blog/index.php/economics/
  21. 21. 21Increased dimensions: Firstly, the company invested in enormous warehouses to stock its inventoryof books, DVDs, computer peripherals. This allows it to benefit from the law of increased dimension.Buying power: Amazon has significant monopsony power when it purchases books directly frompublishers, thereby bypassing its reliance on wholesalers and giving it a higher profit margin.Learning by doing and first-mover advantage: Amazon is benefiting from learning by doing havingbeen one of the first major players in the online retail sector. The unit costs of production tend todecline in real terms as a result of production experience as businesses cut waste and find the mostproductive means of producing output on a bigger scalePre-Orders - Amazon use a pre-order system for customers which allows it to capture early demandand improve stock (or inventory) forecasting.Less invested capital: As an online retailer, Amazon avoids the need for retail stores – oneadvantage is that it has lower invested capital in the business and it frees up resources for customerfulfillment and investment in new technology – Amazon distributes to over 200 countries.Shifting stock at speed: Amazon has a much faster stock velocity – measured by the number ofweeks an item remains in stock. For Amazon this is half that of a physical store – and the benefit is areduction in obsolescence loss (the value of unsold stock is estimated to decline by 30% per year)Economies of scale help to give Amazon a significant cost advantage. The business is also lookingto create economies of scope from marketing and broadening the range of products availablethrough the Amazon brand. Among the innovative business ideas under development we canidentify: Merchants@/Marketplace which gives independent (third party) sellers the opportunity to sell their products through the Amazon platform Amazon Enterprise Solutions – where Amazon provides e-commerce technology for a range of partners such as Marks and Spencer, Lacoste, Mothercare and Timex CreateSpace – a new self-publishing platform for books, music and video Amazon Kindle – a portable reader that wirelessly downloads books, blogs, magazines and newspapers to a high-resolution electronic paper display that looks and reads like real paper,Amazon now sells nearly one fifth of the books bought in the UK each year.Suggestions for further reading on economies of scale and scope http://www.tutor2u.net/blog/index.php/economics/
  22. 22. 22Consoles look to hit their stride (BBC news, July 2008)Cost headache for games developers (BBC news, December 2007)Economies of scale in printing (Tutor2u economics blog, March 2008)GM installs worlds biggest rooftop solar panels (Guardian, July 2008)How worlds biggest ship is delivering our Christmas - all the way from China (Guardian)Mobile web reaches critical mass (BBC news, July 2008)Salad production on a massive scale (BBC news, June 2008) http://www.tutor2u.net/blog/index.php/economics/
  23. 23. 23 4. Business RevenuesRevenue (or turnover) is the income generated from the sale of output in product markets. o Average Revenue (AR) = Price per unit = total revenue / output o Marginal Revenue (MR) = the change in revenue from selling one extra unit of outputThe table below shows the demand for a product where there is a downward sloping demand curve. Price per unit Quantity Demanded Total Revenue Marginal Revenue(average revenue) (Qd) (TR) (PxQ) (MR) £s units £s £s 400 220 88000 370 340 125800 315 340 460 156400 255 310 580 179800 195 280 700 196000 135 250 820 205000 75 220 940 206800 15 190 1060 201400 -45Average and Marginal RevenueIn our example in the table above, as price per unit falls, demand expands and total revenue risesalthough because average revenue falls as more units are sold, this causes marginal revenue todecline. Eventually marginal revenue becomes negative, a further fall in price (e.g. from £220 to£190) causes total revenue to fall.Because the price per unit is declining, total revenue is rising at a decreasing rate and will eventuallyreach a maximum (see the next paragraph).Elasticity of Demand and Total RevenueWhen a firm faces a perfectly elastic demand curve, then average revenue = marginal revenue (i.e.extra units of output can all be sold at the ruling market price).However, most businesses face a downward sloping demand curve! And because the price per unitmust be cut to sell extra units, therefore MR lies below AR. In fact he MR curve will fall at twice therate of the AR curve. You don’t have to prove this for the exams – but it is worth remembering thatthe marginal revenue curve has twice the slope of the AR curve!Maximum total revenue occurs where marginal revenue is zero: no more revenue can be achievedfrom producing an extra unit of output. This point is directly underneath the mid-point of a lineardemand curve. http://www.tutor2u.net/blog/index.php/economics/
  24. 24. 24 Revenue Total revenue is maximised when MR = 0 Total Revenue (TR) Ped >1 for a price fall along this Price elasticity of length of AR demand = 1 at this output Average Revenue Marginal Revenue (Demand) AR (MR) Output (Q)Total revenue is shown by the area underneath the firm‘s demand curve (average revenue curve). Total revenue (TR) refers to the amount of money received by a firm from selling a given level of output and is found by multiplying price (P) by output ie number of units sold Costs Total revenue at price P1 where marginal revenue is zero P2 A rise in price to P2 causes a reduction in total P1 revenue Average revenue AR Total revenue at price P2 Q2 Q1 Marginal revenue MR Output (Q)Suggestions for further reading on business revenuesCarmakers tackle profit problems (BBC news, July 2008) http://www.tutor2u.net/blog/index.php/economics/
  25. 25. 25Revenue fears hit Vodafone shares (BBC news, July 2008)Price elasticity of demand and total revenue (Bryn Jones Online, You Tube video) http://www.tutor2u.net/blog/index.php/economics/
  26. 26. 26 5. ProfitsThe Nature of ProfitProfit measures the return to risk when committing scarce resources to a market or industry.Entrepreneurs take risks for which they require an adequate expected rate of return. The higherthe market risk and the longer they expect to have to wait to earn a positive return, the greater will bethe minimum required return that an entrepreneur is likely to demand.1. Normal profit - is the minimum level of profit required to keep factors of production in their current use in the long run. Normal profits reflect the opportunity cost of using funds to finance a business. If you decide to put £200,000 of your personal savings into a new business, those funds could have earned a low-risk rate of return by being saved in a bank or building society deposit account. You might therefore use the rate of interest on that £200,000 as the minimum rate of return that you need to make from your investment in order to keep going in the long run!Of course we are ignoring here differences in risk and also the non-financial benefits of running andbuilding your own business or investing funds in someone else‘s project.Because we treat normal profit as an opportunity cost of investing financial capital in a business,we normally include an estimate for normal profit in the average total cost curve, thus, if the firmcovers its ATC (where AR meets AC) then it is making normal profits.2. Sub-normal profit - is any profit less than normal profit (where price < average total cost)3. Abnormal profit - is any profit achieved in excess of normal profit - also known as supernormal profit. A firm earns supernormal profit when its profit is above that required to keep its resources in their present use in the long run. When firms are making abnormal profits, there is an incentive for other producers to enter a market to try to acquire some of this profit. Abnormal profit persists in the long run in imperfectly competitive markets such as oligopoly and monopoly where firms can successfully block the entry of new firms. We will come to this later when we consider barriers to entry in monopoly.Case Study: Sub-normal profits drive mortgage lenders out of the market – for nowWhat is happening in the UK mortgage market? Rarely a day goes by without news of anothermortgage lender reassessing the risk of their housing loans and deciding to pull the plug on some oftheir mortgage products. Following on from the Northern Rock which has virtually stopped lending atall and wants to shift a sizeable portion of its mortgage book onto others, the Co-operative Bank,Lehman Brothers and First Direct have all announced that they are withdrawing two-year fixed ratemortgage products for the time being.All of this is one of the direct results of the credit crunch. The lenders are spinning this as a way ofproviding better service-levels to their existing customers but the reality is that the supply of financein the wholesale money markets has been badly squeezed and this is now feeding through to theretail market for housing loans. It is costing the mortgage lenders more to borrow funds and theirprofit margins have been squeezed to a level where sub-normal profits are being made. Little wonderthat some of the major players are effectively exiting the market by withdrawing some mortgageproducts from sale. Only when conditions improve will they consider a return. Source: Tutor2u Economics Blog, April 2008Calculating economic profitConsider the following example: http://www.tutor2u.net/blog/index.php/economics/
  27. 27. 27The table shows data for an owner-managed firm for a particular year. Total revenue £320,000 Raw material costs £30,000 Wages and salaries £85,000 Interest paid on bank loan £30,000 Salary that the owner could have earned elsewhere £32,000 Interest forgone on owners capital invested in the business £20,000In a simple accounting sense, the business has total revenue of £320,000 and costs of £145,000giving an accounting profit of £175,000. But the firm‘s profit according to an economist should takeinto account the opportunity cost of the capital invested in the business and the income that theowner could have earned elsewhere. Taking these two items into account we find that the economicprofit is £123,000.Profit maximisation Profits are maximised when marginal revenue = marginal costPrice Per Unit Demand / Total Marginal Total Marginal Profit (£) Output Revenue Revenue Cost Cost (£) (units) (£) (£) (£) (£) 50 33 1650 2000 -350 48 39 1872 37 2120 20 -248 46 45 2070 33 2222 17 -152 44 51 2244 29 2312 15 -68 42 57 2394 25 2384 12 10 40 63 2520 21 2444 10 76 38 69 2622 17 2480 6 142 36 75 2700 13 2534 9 166 34 81 2754 9 2612 13 142Consider the example in the table above. As price per unit (average revenue) declines, so demandexpands. Total revenue rises but at a decreasing rate (as shown by column 4 – marginal revenue).Initially the firm is making a loss because total cost exceeds total revenue. The firm moves into profitat an output level of 57 units. Thereafter profit is increasing because the marginal revenue fromselling units is greater than the marginal cost of producing them. Consider the rise in output from 69to 75 units. The MR is £13 per unit, whereas marginal cost is £9 per unit. Profits increase from £142to £166.But once marginal cost is greater than marginal revenue, total profits are falling. Indeed thefirm makes a loss if it increases output to 93 units. http://www.tutor2u.net/blog/index.php/economics/
  28. 28. 28 Revenue Marginal Cost And Cost Profits are increasing when MR > MC Profits are decreasing when MR < MC Q1 Marginal Revenue Output (Q)As long as marginal revenue is greater than marginal cost, total profits will be increasing (or lossesdecreasing). The profit maximisation output occurs when marginal revenue = marginal cost.In the next diagram we introduce average revenue and average cost curves into the diagram so that,having found the profit maximising output (where MR=MC), we can then find (i) the profit maximisingprice (using the demand curve) and then (ii) the cost per unit. The difference between price and average cost marks the profit margin per unit of output. Total profit is shown by the shaded area and equals the profit margin multiplied by output Costs Revenue Supernormal profits at Price P1 and output Q1 Normal profit at Q2 where SRAC AR = AC P1 SRMC AC1 AC2 AR (Demand) Q1 Q2 MR Output (Q)The short run supply decision - the shut-down pointThe theory of the firm assumes that a business needs to make at least normal profit in the long run tojustify remaining in an industry but this is not a strict requirement when the firm will continue toproduce as long as total revenue covers total variable costs or put another way, so long as price per http://www.tutor2u.net/blog/index.php/economics/
  29. 29. 29unit > or equal to average variable cost (AR = AVC). This is sometimes referred to as the shut-down price.The reason for this is as follows. A business‘s fixed costs must be paid regardless of the level ofoutput. If we make an assumption that these costs are sunk costs (i.e. they cannot be recovered ifthe firm shuts down) then the loss per unit would be greater if the firm were to shut down, providedvariable costs are covered. MC ATC Costs, P1 is below average variable cost Revenues AVC A AC1 B P2 P1 C AR MR Q1 Output (Q)Consider the cost and revenue curves facing a business in the short run in the diagram above.  Average revenue (AR) and marginal revenue curves (MR) lies below average cost across the full range of output, so whatever output produced, the business faces making a loss.  At P1 and Q1 (where marginal revenue equals marginal cost), the firm would shut down as price is less than AVC. The loss per unit of producing is vertical distance AC.  If the firm shuts down production the loss per unit will equal the fixed cost per unit AB.  In the short-run, provided that the price is greater than or equal to P2, the business can justify continuing to produce in the short run.Northern Foods decides to mothball a factoryNorthern Foods, which supplies Marks and Spencer, is to mothball a factory making ready-mealsbecause it is no longer economical. They said that, whilst the plant had been profitable in recentyears it was no longer generating enough money to give an adequate return to shareholders. Someanalysts have argued that the decision might be due to the effects of the monopsony power of Marksand Spencer which has demanded discounts of up to 6% from its top suppliers including NorthernFoods. Source: Adapted from news reports, May 2008Deriving the Firm‟s Supply Curve in the Short Run In the short run, the supply curve for a business operating in a competitive market is the marginal cost curve above average variable cost. http://www.tutor2u.net/blog/index.php/economics/
  30. 30. 30 In the long run, a firm must make a normal profit, so when price = average total cost, this is the break-even point. It will therefore shut down at any price below this in the long run. As a result the long run supply curve will be the marginal cost curve above average total cost.The concept of a ‗supply curve‘ is inappropriate when dealing with monopoly because a monopoly isa price-maker, not a ―passive‖ price-taker, and can thus select the price and output combination onthe demand curve so as to maximise profits where marginal revenue = marginal cost.Changes in demand and the profit maximising price and outputA change in demand and/or production costs will lead to a change in the profit maximising price andoutput. In exams you may often be asked to analyse how changes in demand and costs affect theequilibrium output for a business. Make sure that you are confident in drawing these diagrams andyou can produce them quickly and accurately under exam conditions.In the diagram below we see the effects of an outward shift of demand from AR1 to AR2 (assumingthat short run costs of production remain unchanged). The increase in demand causes a rise in themarket price from P1 to P2 (consumers are now willing and able to buy more at a given priceperhaps because of a rise in their real incomes or a fall in interest rates which has increased theirpurchasing power) and an expansion of supply (the shift in AR and MR is a signal to firms to movealong their marginal cost curve and raise output). Total profits have increased. A rise in demand (a shift in AR and MR) causes an expansion of supply, a higher profit maximising price and an increase in supernormal profits Profit Max at Price P2 Costs Profit Max at Price P1 P2 AC P1 MC AC1 AC2 AR2 AR1 (Demand) MR2 Q1 Q2 MR1 Output (Q) http://www.tutor2u.net/blog/index.php/economics/
  31. 31. 31Wiseman dairies hit by profits blowShares in Robert Wiseman, Scotland‘s biggest milk supplier, have taken a hit following news of lowerprofits. Operating profits were reported as falling by 16% after a £6.1m fine levied by the Office forFair Trading for alleged price fixing. The company is also suffering from the effects of higher energy,packaging and distribution costs caused by the rising world price of oil. A third factor is a slump inthe market price of cream. The company has found that it cannot always pass on higher input pricesto customers, partly because of pre-existing milk delivery contracts with some of the majorsupermarkets. Source: Adapted from news reports, May 2008The Functions of Profit in a Market EconomyProfits serve a variety of purposes to businesses in a market-based economic system 1. Finance for investment Retained profits are source of finance for companies undertaking investment projects. The alternatives such as issuing new shares (equity) or bonds may not be attractive depending on the state of the financial markets especially in the aftermath of the credit crunch. 2. Market entry: Rising profits send signals to other producers within a market. When the existing firms are earning supernormal profits, this signals that profitable entry may be possible. In contestable markets, we would see a rise in market supply and lower prices. But in a monopoly, the dominant firm(s) may be able to protect their position through barriers to entry. 3. Demand for factor resources: Scarce factor resources tend to flow where the expected rate of return or profit is highest. In an industry where demand is strong more land, labour and capital are then committed to that sector. Equally in a recession, national output, employment, incomes and investment all fall leading to a squeeze on profit margins and attempts by businesses large and small to cut costs and preserve their market position. In a flexible labour market, a fall in demand can quickly lead to a reduction in investment and cut-backs in labour demand. 4. Signals about the health of the economy: The profits made by businesses throughout the economy provide important signals about the health of the macroeconomy. Rising profits might reflect improvements in supply-side performance (e.g. higher productivity or lower costs through innovation). Strong profits are also the result of high levels of demand from domestic and overseas markets. In contrast, a string of profit warnings from businesses could be a lead indicator of a macroeconomic downturn. http://www.tutor2u.net/blog/index.php/economics/
  32. 32. 32 Net Profit for Manufacturing and Service Businesses Net percentage rate of return on capital employed, seasonally adjusted 22.0 22.0 20.0 20.0 18.0 Services 18.0 16.0 16.0 14.0Rate of return (%) 14.0 12.0 Manufacturing 12.0 10.0 10.0 8.0 8.0 6.0 6.0 4.0 4.0 2.0 2.0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 Source: Reuters EcoWinSteps to higher profitsIn an ideal world, running a business would be easy! You come up with an innovative idea, create anew product or service so popular you can‘t stop people from buying it. Word spreads and, beforeyou know it, sales and profits are growing. In reality, few businesses are able to sit back and watchthe profits roll in. Creating and increasing profitability depends on doing a hundred little things betterthan the existing competition. So what are the best ways for a business to increase its profitability?Method 1: Grow the “Top Line”Every business and every market is different. But for most businesses, the best long-term way toimprove profitability is to increase sales (also known as ―turnover‖). This is for four main reasons: 1. If a business has a high gross profit margin, every extra sale is profitable. Once your turnover reaches the break-even level then each additional sale adds to profits. 2. Acquiring new customers is made easier by greater market presence and reputation. As you grow, unit costs are reduced through economies of scale. 3. If your customers tend to be loyal, the value of each new customer lays not just in the immediate sale, but in future sales as well. The cost of selling to existing customers is always lower than the cost of acquiring new customers. 4. Defending a market share against competitors is easier than defending high profit margins. http://www.tutor2u.net/blog/index.php/economics/
  33. 33. 33Many businesses operate in what are called “low growth” markets - where expansion only comesby taking a bigger share of the available demand. Low growth markets tend to be in markets whereincome elasticity of demand is low, so that as the real incomes of consumers increase, there islittle positive effect on market demand.Method 2: Keep Costs under ControlIf a business has a low gross profit margin, reducing direct costs increases the profit on each sale.Eliminating overheads has an immediate impact on profit. Every business can increase profitability byreducing hidden costs. Hidden costs include the costs of employing inappropriate people since poorrecruitment can lead to lower quality, increased training costs and ultimately redundancy costs.Suggestions for further reading on profitsA selection of recent news articles on the profitability of businesses in different markets andindustries and how changes in demand and costs affect prices and profits.Dominos delivers stronger profits (BBC news, July 2008)Fuel costs eat into Fedex profit (BBC news, March 2008)Grand Theft Auto IV set to break all records (BBC news, April 2008)Gregg‘s warns of increased costs (BBC news, March 2008)Higher oil prices see BP‘s profits surge (Guardian, July 2008)Pubs close as beer sales fall (BBC news, July 2008)Ryanair slashes fares to boost demand and fill airline capacity (Guardian, August 2008)Should the British pub get a government subsidy? (BBC news, July 2008)Silverjet calls in administrators (BBC news, June 2008)Supporters count the cost of following a Premiership footie club (Tutor2u blog, March 2008)Weak dollar boosts Nike profits (BBC news, March 2008)Wolseley hit by housing slowdown (BBC news, July 2008) http://www.tutor2u.net/blog/index.php/economics/
  34. 34. 34 6. What Objectives Do Firms Have?In this chapter we consider a range of differentbusiness objectives – much depends on theownership and control of a business and the type ofmarket in which it operates.Profit maximisationThe traditional theory of the firm tends to assume thatbusinesses possess sufficient information, marketpower and motivation to set prices or their productsthat maximise profits. This assumption is nowcriticised by economists who have studied theorganisation and objectives of modern-daycorporations.Why might a business depart from profit maximisation?There are numerous possible explanations. Some relate o the lack of accurate informationrequired to undertake profit maximising behaviour. Others concentrate on the alternative objectivesof businesses. We start first with the effects of imperfect information.It might be hard for a business to pinpoint precisely their profit maximising output, as they cannotaccurately calculate marginal revenue and marginal costs. Often the day-to-day pricing decisions ofbusinesses are taken on the basis of ―estimated demand conditions.‖Secondly, most modern businesses are multi-product firms operating in a range of separatemarkets across countries and continents – as a result the volume of information that they have tohandle can be vast. And they must keep track of the ever-changing preferences of consumers. Theidea that there is a neat, single profit maximising price is redundant.Behavioural Theories of the FirmBehavioural economists believe that modern corporations are complex organizations made upvarious stakeholders. Stakeholders are defined as any groups who have a vested interest in theactivity of a business. Examples might include: o Employees within a business o Managers employed by the firm o Shareholders – people who have an equity stake in a business o Customers in the market o The local community o The government and it‘s agencies including local governmentEach of these groups is likely to have different objectives or goals at points in time. The dominantgroup at any moment can give greater emphasis to their own objectives – for example price and http://www.tutor2u.net/blog/index.php/economics/
  35. 35. 35output decisions may be taken at local level by managers – with shareholders taking only a distantand imperfectly informed view of the company‘s performance and strategy.If firms are likely to move away from pure profit maximising behaviour, what are the alternatives? 1. Satisficing behaviour involves the owners setting minimum acceptable levels of achievement in terms of business revenue and profit. 2. Sales Revenue MaximisationThe objective of maximising sales revenue rather than profits was initially developed by the work ofWilliam Baumol (1959). His research focused on the behaviour of manager-controlled businesses.Baumol argued that annual salaries and other perks might be closely correlated with total salesrevenue rather than profits. Companies geared towards maximising revenue are likely to makefrequent and extensive use of price discrimination (or yield management) as a means of extractingextra revenue and profit from consumers. 3. Managerial Satisfaction modelAn alternative view was put forward by Oliver Williamson (1981), who developed the concept ofmanagerial satisfaction (or managerial utility). This can be enhanced by raising sales revenue. Costs Profit Max at Price P1 Revenue Max at Price P2 AC P1 MC P2 AC1 AC2 AR (Demand) Q1 Q2 Output (Q) MRPrice and output differs if the firm changes its objective from profit to revenue maximisation.Assuming that the firm‘s costs remain the same, a firm will choose a lower price and supply a higheroutput when sales revenue maximisation is the main objective.The profit maximising price is P2 at output Q2 whilst the revenue maximising price is P1 at outputQ1.A change in the objectives of the business has an effect on welfare and in particular the balancebetween consumer and producer surplus. Consumer surplus is higher with sales revenuemaximisation because output is higher and price is lower. http://www.tutor2u.net/blog/index.php/economics/
  36. 36. 36Cadbury abandons its profit targetCadbury Schweppes Plc, the manufacturer of Dairy Milk chocolate has decided to scrap itsprofitability target in the wake of a sharp increase in the costs of their raw materials. Three years agoCadbury announced targets for annual improvements in profit margins ranging from 0.5 to 0.75%.But the rising price of oil-based raw materials and the world market price of cocoa and sugar haveconspired to make meeting this target impossible. Prospects for profits have also been adverselyaffected by the hot summer which has hit demand for chocolate and the unplanned recall of severalhigh profile products because of fears of salmonella poisoning. The business is a major globalpresence in the confectionery market with an estimated ten per cent world market share. In June2007, Cadbury announced that it planned to cut its workforce by 15%. The reorganisation will costCadbury about £450m in a one-off charge. Adapted from Tutor2u blog, November 2006 and news reports, June 2007Social Entrepreneurs – “not just for profit” businessesUnderneath the surface of an economy dominated by corporate giants, a new breed of business isflourishing, where profit is not always the bottom line; these are entrepreneurs operating for a socialpurpose and not just for profit. A social enterprise is a business that has social objectives whosesurpluses are reinvested for that purpose in the business or the community, rather than being drivenby the need to seek profit to satisfy investors. Rather than maximise shareholder value and distributedividends, a social enterprise is looking to achieve social and environmental aims over the long term.Examples include o Café Direct o Fifteen Foundation (Jamie Oliver) o Fair Trade o Housing Associations o Traidcraft o Micro-credit developed by the o Divine Chocolate Grameen Bank and its founder, the o The Eden Project Nobel-Prize winner Muhammad Yu Social Entrepreneurship An example from India Devi Prasad Shetty strives to make sophisticated health care in India available to all irrespective of their economic situation or geographic location. He founded the Narayana Hrudayalaya Hospital in Bangalore in 2001 and co-founded the Asia Heart Foundation. In addition, Shetty has built a network of 39 telemedicine centres to reach out to patients in remote rural areas. Together, the network of hospitals performs 32 heart surgeries a day. Almost half the patients are children and babies. Sixty percent of the treatments are provided below cost or for free. And one from the UK The 2008 Independent Social Entrepreneur of the Year award went to Belu Water, a bottled water company that donates all of its profits to global clean water projects. The company uses carbon- neutral packaging in the form of a compostable bottle made from corn. Belu is the first carbon- neutral product being stocked at Tesco. The bottles look like ordinary bottles and can be recycled with plastics or commercially composted back to soil in just eight weeks. Among its clean water projects, Belu has installed hand pumps and wells for 20,000 people in India and Mali, and it is also working on a rubbish-muncher to clean up the Thames. The company has a pledge that each bottle of mineral water sold will translate as clean water for one person for one month. http://www.tutor2u.net/blog/index.php/economics/
  37. 37. 37 Source: Adapted from news reports, January 2008See Young, Gifted and not for Profit (BBC radio 4 In Business) and also the economic impact ofthe Eden project. Other good sites include: Schwab Foundation for Social EntrepreneurshipNot for Profit BusinessesThese are charities, community organisations that are run on commercial lines e.g. Network Rail:Network Rail o Took over the rail network in October 2002 o Stated purpose is to deliver a safe, reliable and efficient railway for Britain. o It is a company limited by guarantee – whose debts are secured by the government o Network Rail is a private company operating as a commercial business and regulated by the Office of Rail Regulation o Network Rail is a "not-for-dividend" company, which means that all of its profits are invested in the railway network. o Train operating companies pay Network Rail for use of the rail infrastructureBusinesses required to main a loss-making service on social groundsA good example here is the Royal Mail which is required to maintain a universal national postaldelivery service throughout the UK for a uniform price. Household mail makes a loss, cross-subsidised by business mail – although this market is shrinking for the Royal Mail because of theintroduction of fresh competition from Jan 2006. The Post Office Ltd is a subsidiary of the RoyalMail Group plc – it runs substantial losses on the network or rural post offices and has been undergreat pressure to close hundreds of offices to stem losses.Suggestions for further reading on business objectives and business ownershipAustralian expansion proves a move too far for Starbucks (Tutor2u blog, July 2008)Founder of bottled water company honoured for work in Third World (Independent, Jan 2008)How business embraced charity (The Observer, June 2008)Making profit with a conscience (BBC news, March 2008)Motivated by change (Independent, July 2004)Mysterious death of the petrol station (VVC news, March 2008)Network Rail announces pre-tax profit of £1.6bn (BBC news, June 2008)Ryanair flies into the path of an economic storm (Tutor2u blog, July 2008)Sony predicts TV and game profits (BBC news, June 2008)Survival challenge for social enterprises (Guardian, July 2008)Wind farm co-op raises thousands (BBC news, July 2008) http://www.tutor2u.net/blog/index.php/economics/
  38. 38. 38 7. Divorce between Ownership and ControlOwnership and controlThe owners of a private sector company normally elect a board of directors to control thebusiness‘s resources for them. However, when the owner sells shares, or takes out a loan or bondto raise finance, they may sacrifice some of their control. Other shareholders can exercise theirvoting rights, and providers of loans often have some control (security) over the assets of thebusiness.This may lead to a degree of conflict between them as these different stakeholders may havedifferent objectives. The flow chart below attempts to show the divorce between ownership andcontrol. Principals: Shareholders OWNERSHIP Control Mechanisms: Pressures from the stock market and from hedge funds and private investors Regular meetings with shareholders (e.g. the AGM) Scrutiny in the financial press Performance related pay (to provide incentives) CONTROL Agents: Board of Directors Senior ManagementThe Principal Agent ProblemHow do the owners of a large business know that the managers they have employed and who aremaking the key day-to-day decisions operate with the aim of maximising shareholder value in boththe short term and the long run?This lack of information is known as the principal-agent problem or ―agency problem‖. In otherwords, one person, the principal, employs an agent (e.g. a sales or finance manager) to performtasks on his behalf but he or she cannot ensure that the agent always performs them in preciselythe way the principal would like. The decisions and the performance of the agent are bothimpossible and expensive to monitor and the incentives of the agent may differ from those ofthe principal. The principal agent problem is illustrated in the flow chart above. http://www.tutor2u.net/blog/index.php/economics/

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