A2 Micro Business Economics


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Unit 3 Business economics revision companion

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A2 Micro Business Economics

  1. 1. A2 Microeconomics Business Economics Study Companion GEOFF RILEY 10th Edition - 2013
  2. 2. © Tutor2u Limited 2013 2 A2 Microeconomics Study Companion – 2013 I gratefully acknowledge the help given in the preparation of this study companion by my own students and I also acknowledge some of the ideas and arguments put forward in articles written by Bob Nutter, Tom White, Penny Brooks, Mark Seccombe, Mo Tanweer, Jim Riley, David Carpenter, Ben White, Liz Veal, Ruth Tarrant, Ben Cahill, Ben Christopher and Mark Johnston Table of Contents 1. Objectives of Businesses and the Growth of Firms ...............................................................................3 2. The Growth of Firms.............................................................................................................................7 3. Calculating the Revenue of a Firm ......................................................................................................16 4. Calculating a Firm’s Costs..................................................................................................................18 5. Production in the Short and the Long Run...........................................................................................24 6. Long Run Costs: Economies of Scale.................................................................................................27 7. Diseconomies of Scale .......................................................................................................................37 8. Profits.................................................................................................................................................39 9. Divorce between Ownership and Control ............................................................................................47 10. Measuring Market Concentration ........................................................................................................49 11. Barriers to Entry and Exit in Markets...................................................................................................52 12. Technological Change, Costs and Supply in the Long-run ..................................................................56 13. Perfect Competition – Economics of Competitive Markets...................................................................60 14. Monopolistic Competition....................................................................................................................67 15. Model of Pure Monopoly.....................................................................................................................69 16. Monopoly and Price Discrimination in Markets....................................................................................71 17. Monopoly and Economic Efficiency.....................................................................................................76 18. Oligopoly – Non Collusive Behaviour ..................................................................................................85 19. Oligopoly – Collusion between Businesses.........................................................................................92 20. Oligopoly - Game Theory....................................................................................................................96 21. Contestable Markets...........................................................................................................................99 22. Monopsony Power in Product Markets..............................................................................................105 23. Consumer and Producer Surplus......................................................................................................110 24. Summary on Market Structures ........................................................................................................113 25. Government Intervention – Competition Policy..................................................................................116 26. Government Intervention – Price Regulation.....................................................................................122 27. Government Intervention - Privatisation and Nationalisation..............................................................128 28. The Private Finance Initiative (PFI) ...................................................................................................134 29. Industry in Focus - Water..................................................................................................................137 30. Business Economics Glossary..........................................................................................................140
  3. 3. © Tutor2u Limited 2013 3 1. Objectives of Businesses and the Growth of Firms Businesses supply goods and services to markets:  Private sector businesses seek to make a commercial rate of return for the capital invested by their shareholders. Examples of private sector businesses include the retailer Tesco the express parcel and logistics operator FedEx, the bank Santander and the electronics corporation Samsung.  Public sector businesses are wholly or part-state owned. Examples of public sector firms include Network Rail, East Coast Trains and the Royal Mail. The usual theory of the firm assumes that businesses have sufficient information, market power and motivation to set prices for their products that maximise their total profits  This assumption is criticised by economists who have studied the organisation and objectives of modern-day corporations both large and small. Businesses have a much wider range of objectives  Not only do most businesses frequently move away from pure profit-seeking behaviour, many are deliberately organised and operate in a way where profit is not the only objective. Examples of different business objectives There will always be a range of business objectives. An increasing number of companies are refocusing their priorities beyond profit and towards the welfare of their suppliers, employees and the planet. 1. Profit maximisation (this occurs where marginal revenue = marginal cost) 2. Revenue maximisation (this occurs where marginal revenue = zero) 3. Increasing and protecting market share 4. Breaking into a new market and making sufficient profit to remain there in the long run 5. Surviving a recession and/or a persistently slow recovery 6. Pursuing ethical business objectives (e.g. promoting corporate social responsibility) 7. Providing a public service – see later sections on nationalised (state-owned) industries Why might a business depart from profit maximisation? Some explanations relate to the lack of accurate information required to set profit maximising prices. Others concentrate on the alternative objectives of businesses.  Imperfect information: o It might be hard for a business to pinpoint their profit maximising output, as they cannot accurately calculate marginal revenue & cost o Day-to-day pricing decisions are taken on the basis of “estimated demand” or “rules of thumb”. Businesses can take advantage of their market experience when setting prices o A business might look to add a profit margin on top of average cost – “cost-plus pricing”.  Multi-product businesses: o Most businesses are multi-product firms operating in a range of markets across countries and continents – the volume of information that they have to handle can be vast. And they must keep track of the ever-changing preferences of consumers. o The idea that there is a neat, single profit maximising price is redundant
  4. 4. © Tutor2u Limited 2013 4 Maximisers and Satisficers Maximisers behave in a traditional economic way and always try to make the best possible choice from the available alternatives. Satisficers examine only a limited set of alternatives, and choose the best between them Source: Professor Paul Ormerod Behavioural Theories of the Firm Behavioural economists believe that large businesses are complex organizations made up of different stakeholders – i.e. groups made up of different people who each have a vested interest in the activity of a business. Examples include: o Managers employed by a business and other employees o Shareholders – people who have a stake in a business o Customers o The government and it’s agencies Each group is likely to have different objectives or goals at points in time. The dominant group at any moment can give greater emphasis to their own objectives – for example price and output decisions may be taken at a local level by managers – with shareholders taking only a distant 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 is when businesses move away from pure profit maximisation and choose instead to aim for minimum acceptable levels of achievement in terms of revenue and profit. Satisficing is when someone only considers a limited number of alternatives 2. Sales Revenue Maximisation  The objective of maximising sales revenue rather than profits was developed by William Baumol whose work focused on the behaviour of manager-controlled businesses  Baumol argued that annual salaries and perks are linked to sales revenue rather than profits  Companies geared towards maximising revenue are likely to make extensive use of price discrimination to extract extra revenue and profit from consumers. A firm might also aim to maximise sales revenue rather than profits because it wishes to deter the entry of new firms  If a firm decides to aim to maximise sales revenue rather than profits, one of the consequences might be a reduction in the price of the firm’s shares 3. Managerial Satisfaction model An alternative view was put forward by Oliver Williamson (1981), who developed the concept of managerial satisfaction (or managerial utility)  Assuming that the firm’s costs remain the same, a firm will choose a lower price and supply a higher output when sales revenue maximisation is the main objective  In the following diagram, the normal profit maximising price is P1 at output Q1 and the revenue maximising price is P2 at output Q2  Consumer surplus is higher with sales revenue maximisation because output is higher and price is lower. Producer surplus is greater when profits are maximised
  5. 5. © Tutor2u Limited 2013 5 Edinburgh Bicycle Co-operative operates across eight stores in Scotland and England as well as online and has around 100 workers, each with an equal share in the business Diagram to show different objectives and different price and output combinations Social Entrepreneurs / Social Enterprises  A social business or a social enterprise is a business created to address a social problem or issue that only makes enough profit to sustain itself  Profits are reinvested for one or more social purposes in the community, rather than being driven by the need to seek profit to satisfy investors  Social entrepreneurs are looking to achieve social, cultural and environmental aims  In the summer of 2013, research published found that there are currently 70,000 social enterprises in the UK contributing £18.5bn to the economy and employing almost 1m people. They include Jamie Oliver’s Fifteen restaurant chain and The Big Issue magazine sold by homeless people Co-operative Businesses  Co-operative businesses (Co-ops) are owned and run by their members, who can be customers, employees or groups of businesses.  The supermarkets-to-funerals Co-op Group is the biggest, followed by John Lewis Partnership, the retailer. Farmers’ co-ops are also popular in the UK.  Other co-ops include community pubs, supporter-run football clubs and foster care and childcare providers  These types of business are founded and run on principles of shared ownership, shared voice and shared profits. Costs Output (Q) AC AR (Demand) MR MC Q1 P1 AC1 Profit Maximized at Price P1 P2 AC2 Q2 Revenue Maximized at Price P2
  6. 6. © Tutor2u Limited 2013 6 Not for Profit Businesses These are charities, community organisations that are run on commercial lines e.g. Network Rail: o Network Rail: Their 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 operates as a commercial business and regulated by the Office of Rail Regulation o Network Rail is a "not-for-dividend" company - profits are invested in the railway network. o Train operating companies (TOCs) pay Network Rail for use of the rail infrastructure o They are given targets for punctuality and safety Ethical Businesses – Corporate Social Responsibility Corporate social responsibility happens when companies integrate social and environmental concerns in their business operations and in their interaction with their stakeholders on a voluntary basis Key reasons why firms are increasingly embracing CSR  Altruism – being a good citizen  Window-dressing to appease stakeholders  Contracting benefits – e.g. helps recruit, motivate and retain employees  Customer-related motivation: attract customers; brand positioning  Lower production costs (packaging, energy usage)  Risk management – address potential legal or regulatory action  Improved access to capital – for example, the rise ethical investment funds looking to make equity investments in companies with strong CSR reputations Michael Porter - Shared Value and the Limitations of CSR Narrow views about how to create profit has created disconnect between businesses and society and needs to change according to Harvard Business School Professor Michael Porter. “A growing number of companies known for their hard-nosed approach to business—such as GE, Google, IBM, Intel, Johnson & Johnson, Nestlé, Unilever, and Wal-Mart—have already embarked on efforts to create shared value by looking again at the intersection between society and corporate performance.” Shared value is creating economic value by creating social value In recent times, creating value has tended to focus on short-termist thinking - Businesses have been long on driving huge sales and output volumes, downsize and de-layering inefficient management and generally responding to pressure from financial markets to deliver immediate results through cost-cutting, dynamic pricing and increasingly tough marketing that can often persuade people to buy things that are not good for them. This involves a recalibration and a rethinking about what a product really is and what needs a business is meeting, for example in the food industry, products that are nutritious and healthy rather than focus on volume, lower unit costs and higher profits. He notes to increasing prominence of social entrepreneurs with revenue generating business models. Consumers looking at the world differently and expressing their preferences in strong ways - this is already having a direct effect on supermarket behaviour.
  7. 7. © Tutor2u Limited 2013 7 2. The Growth of Firms Why do firms grow? 1. Profit motive: a. Businesses grow to achieve higher profits and raise returns for their shareholders b. The stock market valuation of a firm is influenced by expectations of future sales and profit streams so if a company achieves disappointing growth figures, this might be reflected in a fall in the share price. This then opens up the risk of a hostile take-over and makes it more expensive for a quoted company to raise fresh capital by issuing new shares 2. Cost motive: a. Economies of scale have the effect of increasing the productive capacity of the business leading to lower long run average costs. They help to raise profit margins at a given price 3. Market power motive: a. Firms may wish to increase market dominance giving them increased pricing power b. This market power can be used as a barrier to the entry of new businesses c. Larger businesses can build and take advantage of buying power (monopsony) 4. Risk motive: a. Growth might be motivated by a desire to diversify production and/or sales so that falling sales in one market might be compensated by stronger demand in another sector b. This is known as achieving economies of scope and is a feature of conglomerates 5. Managerial motives: Behavioural theories of the firm predict that business expansion might be accelerated by senior managers whose objectives are different from the major shareholders. How do firms grow? Organic Growth Organic growth is also known as internal growth. It happens when a business expands its own operations rather than relying on takeovers and mergers. Organic growth might come about from:  Increasing existing production capacity through investment in new capital & technology  Development & launch of new products  Finding new markets for example by exporting into emerging countries  Growing a customer base through marketing
  8. 8. © Tutor2u Limited 2013 8 External Growth External growth takes place through mergers or take-overs. There are many potential advantages:  Faster speed of access to new product or market areas  Increase market share / increased market power  Access economies of scale (perhaps by combining production capacity)  Secure better distribution channels / control of supplies  Acquire intangible assets (brands, patents, trademarks)  Overcome barriers to entry to target markets  Defend a business against a takeover threat  Enter new segments of existing market  To take advantage of deregulation in an industry Horizontal integration: When two businesses in the same industry at the same stage of production become one – for example a merger between two car manufacturers or drinks suppliers. Recent examples of horizontal integration include:  Cadbury buying Innocent Smoothies  Cadbury was bought by the American Kraft Foods in 2010. It was then spun off into Mondelez International - Kraft Group's international snack and confectionary business  Lloyds Banking Group taking over HBOS  Tata buying Jaguar Land Rover from Ford Motors  Iberia and BA merger  Costa Coffee (Whitbread) buying Coffee Nation  Volkswagen buying Porsche  Arla, the Swedish-Danish dairy co-operative merged with British co-op Milk Link in 2012  Two car manufacturers (e.g. Daimler & Chrysler)  Two tour operators (e.g. TUI & First Choice)  Asda buying Netto (food supermarkets)  Amazon buying LoveFilm  Virgin Money buying Northern Rock The advantages of horizontal integration include the following: 1. It increases the size of the business and allows for more internal economies of scale – lower long run average costs – improved profits and competitiveness 2. One large firm may need fewer workers, managers and premises than two – a process known as rationalization again designed to achieve cost savings 3. Mergers often justified by the existence of “synergies” Examples of Organic Growth Poundland Poundland was formed in 2000 and has grown strongly due to a focus on a constantly rotating product range sold at a single price point. Ten years after starting-up, Poundland was sold to a US venture capital firm for £200 million, when its revenues had grown from nothing to over £400m per year. The organic strategies was to open new stores in suitable locations and repeat the formula of offering heavily discounted products to a mainly female customer base. Poundland’s profits grow 26.5% in the year to April 2012. It will open 60 new stores in 2012 BSkyB In 2004, BSkyB set a long-term objective of growing its household subscriber base to 10 million households/customers. The strategy was to grow organically by focusing on investment in content and innovation. 2003: Revenue £3.2bn Profit £128m 2010: Revenue £5.9bn Profit £1,173m Subway Subway is an American restaurant franchise that mainly sells submarine sandwiches (subs) and salads. In 2001, Subway had just 52 franchised outlets in the UK, a tiny number compared with its 14,800 around the world in 2001 As of April, 2011, Subway operates 34,501 stores in 98 countries and territories. There are currently 1,500 Subway franchises in the UK and the company has recently announced a new objective to grow that to 3,000 outlets in the next three years
  9. 9. © Tutor2u Limited 2013 9 Vertical Integration for a UK Chocolate Retailer Hotel Chocolat is a British cocoa grower and chocolatier and undoubtedly one of the big retail success stories in recent years. The business has annual sales exceeding £70 million a study from Bain and Company published in Marketing week recently placed Hotel Chocolat as the 4th most consumer advocated brand in the world, and the only UK brand to appear in the top ten. Hotel Chocolat is a vertically integrated business that owns and operates cocoa plantations in St Lucia (the Rabot Estate pictured above) and which roasts and manufactures chocolate in Cambridgeshire. The business started with producing peppermints for the corporate market and Hotel Chocolat was one of the early adopters of online e-retailing in the UK in the early 1990s. Digital channels have proved effective throughout the growth story and sales from the web site now account for around forty per cent of the total. 4. Creates a wider range of products - (diversification). Opportunities for economies of scope 5. Reduces competition by removing rivals – increases market share and pricing power Vertical integration: Vertical Integration involves acquiring a business in the same industry but at different stages of the supply chain. The supply chain is the process by which production and distribution gets products to the customer. 1. Forward vertical: Closer to the final consumers of the product e.g. a manufacturer buying a retailer 2. Backward vertical: Closer to raw materials in the supply chain e.g. a steel firm buying a coal mine Examples of vertical integration might include the following:  Film distributors owning cinemas and digital streaming platforms  Brewers owning/operating pubs (forward vertical) or buying hop farms (backward vertical)  Crude oil exploration all the way through to refined product sale  Record labels and music stations  Drinks manufacturers integrating with bottling plants  Hewlett Packard purchasing Autonomy, a UK based software firm (Aug 2011)  Google - a software business - buying Motorola, a phone maker  Publishing group Pearson paid more than £500m for Grupo Multi - Brazil’s largest private network of English language schools (December 2013)  Technology companies growing vertically through hardware, software and services Examples of recent acquisitions in the technology space Yahoo bought Tumblr for $1.1 bn in May 2013. This followed previous purchases such as Delicious, an online-bookmarking service, and GeoCities, which hosts websites. Yahoo owns the photo-sharing site Flickr Google bought YouTube, a video site, in 2006 Facebook acquired Instagram, a photo-sharing service in 2012 Amazon bought Goodreads, an online book-recommendation service Twitter acquired UK’s Tweet Deck for $40m in 2011 Apple: In July 2013 Apple acquired Hop Stop, an app for helping people find their way across town using public transport, and Locationary, which provides information about the locations of local businesses Apple: in November 2013, Apple announced that it had acquired PrimeSense, Israeli tech business that developed motion-detection software in gaming sensor Kinect Google: in February 2014 - Google bought sound authentication firm SlickLogin
  10. 10. © Tutor2u Limited 2013 10 Advantages of Vertical Integration The main advantages of vertical integration are: 1. Control of the supply chain – this helps to reduce costs and improve the quality of inputs into the production process 2. Improved access to key raw materials perhaps at the expense of rival businesses 3. Better control over retail distribution channels e.g. pub companies who ensure that their beers and wines are sold in tenanted pubs and clubs 4. Removing suppliers, information from competitors which helps to make a market less contestable Lateral / Conglomerate Integration Lateral integration involves companies joining together that produce similar but related products. Examples include:  Google and You Tube  Proctor & Gamble acquiring Gillette in 2004  Whitbread bought Coffee Nation vending machines (March 2011)  Microsoft’s takeover of Skype (May 2011)  SSL International, the manufacturer of Durex condoms was taken over by healthcare conglomerate Reckitt Benckiser (2010) One of the main advantages of lateral integration is to exploit economies of scope Out-sourcing Over a third of UK companies now do some of their production work abroad, whilst 10% have over half of their manufacturing offshore in lower cost locations. Dyson relocated production abroad to Malaysia, whilst keeping their research and design operations in the UK. There are several factors promoting outsourcing as a business strategy: (1) Technological change – Information, communication and telecommunication costs are falling - this makes it easier to outsource service and manufacturing operations to sub-contractors in other countries. Technological advances now promote "Just in time delivery" inventory strategies for the delivery of components and finished products and encourage the development of "virtual manufacturing" (2) Increased competition which increases the pressure on businesses to achieve lower costs as a means of maintaining market share Business acquisitions – the concept of synergy Synergy can be defined as when the whole is greater than the sum of the individual parts In an acquisition synergy arises in two broad ways: Many cost saving synergies arise from the greater scale of the enlarged business. Two firms may be able to use greater bargaining power to negotiate lower prices from suppliers, or to demand better profit margins from their distributors. Acquisitions nearly always involve the removal or downsizing of duplicated functions in the two businesses. For example, if a publicly-quoted company is taken over by another firm, there is no need for both businesses to keep their full senior management structure. There only needs to be one Chairman, one CEO etc. Revenue synergies (higher sales) are often harder to identify and achieve - but they are an important part of making an acquisition successful. After all, a successful acquisition should mainly be about helping a firm to grow more rapidly rather than simply taking costs out of two businesses put together.
  11. 11. © Tutor2u Limited 2013 11 Cineworld and Picturehouse Takeover In December 2012 a takeover worth £47 million was agreed between Cineworld and Picturehouse cinema chains. Cineworld operates 79 cinemas in the UK, the majority of which are multiplex cinemas. As a result of this deal Cineworld acquired an additional 21 cinemas trading under the Picturehouse brand. These cinemas are smaller cinemas of between one - three screens. Picturehouse advertises that the focus of its film offering is targeted at art- house and foreign language films. Cineworld has identified the art-house cinema sector as a growth opportunity and has said that it plans to open a further 10 Picturehouse cinemas in locations around the UK. The UK’s cinema sector has been consolidating for years. Three players – Vue, Odeon & UCI, and Cineworld – now control 70 per cent of the market between them. In April 2013, the Office of Fair Trading (OFT) referred the completed acquisition by Cineworld plc of City Screen Limited to the Competition Commission (CC) after concerns the merger reduces competition and could restrict choice and increase prices for cinema-goers. The OFT identified that, in five local areas - Aberdeen, Brighton, Bury St. Edmunds, Cambridge and Southampton - the deal raises a realistic prospect of a substantial lessening of competition. Source: Adapted from news reports Joint Ventures between Businesses  Joint ventures occur when businesses join together to pursue a common project  The businesses remain separate in legal terms  Joint ventures are becoming common as firms want to benefit from collaborative work in reaching a mutually-agreed strategic target. An example might be joint-research projects to share the fixed costs Examples of joint ventures include:  Vodafone & Telefónica agreed in 2012 to share more of their mobile network (which contains more than 18,500 mobile mast sites). This was seen as a response to Everything Everywhere - JV between T- Mobile and Orange (current leader in the UK market)  Vodafone also has a joint venture with Verizon Wireless in the United States  BMW and Toyota agreed a partnership in 2011 to co- operate on hydrogen fuel cells, vehicle electrification, lightweight materials and a future sports car. Partnership agreements between competing automakers are becoming increasingly common in the industry as manufacturers seek to pool efforts on costly technologies  West Coast – a joint venture between Virgin Rail and Stagecoach  Google and NASA developing Google Earth  Hollywood studios combining to fight internet piracy  Renault-Nissan’s joint venture with Indian firm Bajaj to produce a £1,276 car  Intertrust Technologies, a JV between Sony and Philips  Alliances in the airline industry e.g. Star Alliance and One World  Burger King, the US fast food restaurant chain plans to open 1,000 stores in China through a new joint venture with a Turkish private equity business  Starbucks agreeing a joint venture with Tata Beverages to break into the Indian retail market  Nokia Siemens Networks  Joint Ventures between universities to deliver Massive Open Online Courses (MOOCs) – a fast-expanding sector of the higher education industry  Every one of the world’s 24 biggest carmakers by sales operates some form of alliance or joint venture with another large carmaker.
  12. 12. © Tutor2u Limited 2013 12 Benefits and Costs of Acquisitions: Evaluation Comments on Mergers and Takeovers Many takeovers and mergers fail to achieve their aims 1. Debt: Huge financial costs of funding takeovers including the burden of deals that have relied heavily on loan finance 2. Share price: The need to raise fresh equity through a rights issue to fund a deal which can have a negative impact on a company's share price. Over the three to five years after the deal on average, the share price of the acquiring company tends to drop 3. Clash of cultures: Many mergers fail to enhance shareholder value because of clashes of corporate cultures and a failure to find the all-important "synergy gains“ - Cultural incompatibility is common in the case of cross-border acquisitions 4. Loss of human capital: The business may suffer a loss of personnel & customers post acquisition 5. Paying too much: With the benefit of hindsight we often see the ‘winners curse’ - i.e. companies paying over the odds to take control of a business and ending up with little real gain in the medium term. A good example would be the doomed takeover of ABM-AMRO by Royal Bank of Scotland 6. Job Losses: Integration often leads to sizeable job losses - Google, which acquired Motorola Mobility (a manufacturer of mobile phones) for $12.5bn recently announced that it will make 20% of Motorola’s workforce redundant 7. Bad timing – mergers and takeovers that take place towards the end of a sustained boom can often turn out to be damaging for both businesses. A good example occurred in the UK property market How takeovers and mergers fit into strategic choice Innovation Diversification International Expansion Cost leadership Strategy Method Organic / interna Takeovers / m Joint ventures or stra Takeovers and mergers are rarely forced on a business - they are optional If M&A is optional, then there must be some alternatives E.g. could a joint venture or strategic alliance be as effective as a cross-border ta
  13. 13. © Tutor2u Limited 2013 13 with Taylor Woodrow's merger with Wimpey in a £5bn all-shares deal sealed just as property prices were peaking. Since then house sales have collapsed due to the credit crunch and the merged business has suffered huge losses
  14. 14. © Tutor2u Limited 2013 14 Competing in the Land of the Giants The UK dairy processing industry is dominated by a small group of huge milk processing businesses including Mueller Wiseman, Arla and Dairy Crest, the UK's largest supplier. However a cluster of privately owned southwest dairy businesses have bucked the trend of industry consolidation in milk processing. Rodda’s, maker of the famous Cornish clotted cream that embellishes the strawberries at Wimbledon, grew sales by third in 2012 to £29m. Yeo Valley Food, the organic yoghurt and ice cream maker in Blagdon in Somerset, now has sales of about £200m. Wyke Farms in Bruton is a cheese maker with sales of £75m. These small to medium sized businesses have found profitable segments of the industry by producing niche and premium priced products. How can Smaller Businesses Survive and Thrive? Over time there is a clear trend towards larger scale businesses partly because of the pressures of competition; the need to achieve economies of scale and the effects of mergers and takeovers. However there are plenty of examples where businesses are de-merging and divesting themselves of some of their existing assets. And even in industries where giant businesses dominate the market place, there is frequently room for smaller firms to compete and survive profitably. 1. Many smaller businesses act as a supplier / sub- contractor to larger enterprises 2. They might take advantage of a low price elasticity of demand and high income-elasticity of demand for specialist ‘niche’ goods and services – these products can be sold at a higher price and with a bigger profit margin 3. Smaller businesses can avoid diseconomies of scale associated with larger companies 4. Many smaller businesses are run as lifestyle enterprises, their owners are looking to achieve a satisfactory return rather than maximise profits 5. Small-scale businesses are often more innovative, flexible and nimble in responding to changes in market demand conditions. Small Businesses in the British Economy In the UK small and medium sized enterprises (SMEs) have been the engine of job creation for many years, and, indeed, since the financial crisis. Employment in SMEs rose by 2.0% between 2008 and 2012 while large firms reduced their headcount by 1.8%. Cost cutting and redundancies in large companies and the public sector have acted as a spur to self-employment and business start-ups. But surviving and expanding are tough for SMEs. The great majority of small businesses are sole traders or employ a handful of people. Small firms tend to stay small and have a high mortality rate. In 2011, 261,000 firms employing fewer than 100 people were formed in the UK - and 229,000 died. Most new jobs in SMEs come with the initial creation of the business, not from subsequent growth. Despite a high mortality rate, the number of UK small firms has increased to reach 4.8 million by 2012, a rise of 39% over 12 years. Over the same period the number of large businesses employing more than 250 people fell by 19%. What is driving the growth in small businesses? The expansion of services – the dominant sector in Western economies – has been a boon for entrepreneurs. In many service industries capital costs are low, making it easier for small players to enter. Changing consumer tastes and rising incomes have led to growing demand for customisation which favours nimble, niche players. Among those of working age a desire for greater independence has helped boost the ranks of the self-employed. Advances in the internet, computing and telecommunications have eroded some of the advantages of scale previously enjoyed by big business. In reality, large and small companies are mutually dependent. The auto industry relies on networks of small companies providing them with components. Small companies are a source of new ideas which, in sectors such as technology and pharmaceuticals, are often exploited by large businesses. Small firms in turn benefit from knowledge ‘spill-overs’ generated by larger firms and rely upon larger suppliers for business and, at times, credit. Meanwhile, the high failure rate of small businesses can be seen as a dynamic process, a necessary form of creative destruction which, in time, allows a few winners – the Apples, Googles and Facebooks – to become behemoths. Source: Ian Stewart, Deloitte Business Briefing, July 2013
  15. 15. © Tutor2u Limited 2013 15 Demergers and Divestment  This is when a firm decides to split into separate firms  A partial demerger means that the parent company retains a stake in the demerged business  Demergers can also result from government intervention - for example BAA has been compelled by the UK Competition Commission to sell off some airports in Britain including Gatwick & Stansted  Some of the key motivations for de-merger include: o Focusing on core businesses to streamline costs and improve profit margins o Reduce the risk of diseconomies of scale and diseconomies of scope by reducing the range of functions in a business, lower management costs o Raise money from asset sales and return to shareholders o A defensive tactic to avoid the attention of the competition authorities who might be investigating possible monopoly power in an industry / market Examples of recent demergers Demergers are becoming increasingly common in many industries – here are ten examples: 1. The US pharmaceutical company Pfizer sold their infant nutrition business to Nestle and announced a demerger of the animal health business (creating a new company called Zoetis) 2. Demerger of Cadbury's US drinks business creating a business called Dr Pepper Snapple Group 3. Severn Trent Water demerged its waste management business Biffa 4. Demerger of British Gas into a gas pipeline business Transco + an oil and gas exploration company 5. Talk Talk demerged from Carphone Warehouse in 2010 6. Fosters Group de-merging its two main operating divisions – one focusing on beer, the other on wine 7. Punch and Spirit pub groups created out of demerger of Punch Taverns in 2011. Punch Taverns had seen a 95% fall in the share price of the business in the years leading up to the demerger. The business had huge debts and selling off parts of the business was a way of cutting that debt. 8. US food giant Sara Lee sold off their coffee business Douwe Egberts 9. Quantas demerged their airline business and run stand-alone domestic and international airline businesses with each having their own profit and loss account 10. News International announced plans in 2012 to demerge their Film and TV and Publishing businesses. News International as a whole earned $25.3bn in revenue in 2012 with an operating profit of $4.2bn. The business will be split into two. FilmandTV •Fox News •20th Century Fox •Sky •Fox Television Publishing •Dow Jones •Wall Street Journal •New York Post •The Times •The Sun •Harper Collins
  16. 16. © Tutor2u Limited 2013 16 3. Calculating the Revenue of a Firm Revenue is the income generated from the sale of goods and services in a market  Average Revenue (AR) = Price per unit = total revenue / output (the AR curve is the same as the demand curve)  Marginal Revenue (MR) = the change in revenue from selling one extra unit of output  Total Revenue (TR) = Price per unit x quantity The table below shows the demand for a product where there is a downward sloping demand curve. Price per unit (average revenue) Quantity Demanded (Qd) Total Revenue (TR) (PxQ) Marginal Revenue (MR) £s units £s £s 340 460 156400 310 580 179800 195 280 700 196000 135 250 820 205000 75 220 940 206800 15 190 1060 201400 -45 Average and Marginal Revenue  In the table above, as price per unit falls, demand expands and total revenue rises although because average revenue falls as more units are sold, this causes marginal revenue to decline  Eventually marginal revenue becomes negative, a further fall in price (e.g. from £220 to £190) causes total revenue to fall. The Relationship between Elasticity of Demand and Total Revenue  When a firm faces a perfectly elastic demand curve, then average revenue = marginal revenue – each unit sold add the same amount to total revenue  However, most businesses face a downward sloping demand curve! And because the price per unit must be cut to sell extra units, therefore MR lies below AR.  MR curve will fall at twice the rate of the AR curve. You don’t have to prove this for exams – the marginal revenue curve has twice the slope of the AR curve! Maximum Revenue  Maximum total revenue occurs where marginal revenue is zero: no more revenue can be achieved from producing an extra unit of output  This point is directly underneath the mid-point of a linear demand curve  When marginal revenue is zero, the price elasticity of demand = 1  When marginal revenue is zero, if prices were cut total revenue would fall, and if prices were raised total revenue would fall Total revenue when demand has low price elasticity If price elasticity of demand < 1 (i.e. demand is inelastic), if prices are cut then demand rises by a smaller proportion. Cutting price when demand is relatively inelastic means total revenue falls, or MR<0
  17. 17. © Tutor2u Limited 2013 17 Total revenue is shown by the area underneath the firm’s demand curve (average revenue curve). A shift in the average revenue curve (AR) will also bring about a shift in the marginal revenue curve (MR) Seasonal revenues: Many businesses experience seasonal fluctuations in revenues because the strength of demand ebbs and flow at different times of the year. Good examples of seasonal shifts in demand and revenues include beer producers, chocolate and card retailers, tourist attractions, online dating sites, jewellers and perfumery businesses. Output (Q) Revenue Total Revenue (TR) Marginal Revenue (MR) Average Revenue (Demand) AR Total revenue is maximized when MR = 0 Price elasticity of demand = 1 at this output Ped >1 for a price fall along this length of AR Costs Output (Q) Average revenue AR Marginal revenue MRQ1 P1 Total revenue at price P1 where marginal revenue is zero A rise in price to P2 causes a reduction in total revenue P2 Q2 Total revenue at price P2
  18. 18. © Tutor2u Limited 2013 18 4. Calculating a Firm’s Costs  In the short run, at least one factor of production is fixed; this means that output can be increased by adding more variable factors such as employing more workers and buying in more raw materials Fixed costs  Fixed costs do not change with output, firms must pay these even if they shut down  Examples include the rental costs of buildings; the costs of leasing or purchasing capital equipment; the annual business rate charged by local authorities; the costs of employing full-time contracted salaried staff; the costs of meeting interest payments on loans; the depreciation of fixed capital (due solely to age) and also the costs of business insurance.  Any business with significant capacity will have high fixed costs, for example a vehicle manufacturer that spends millions of pounds building a new factory and installing expensive and bulky capital equipment. Fixed costs are the overhead costs of a business.  Total fixed costs (TFC)  Average fixed cost (AFC) = TFC / output  Average fixed costs must fall continuously as output increases because total fixed costs are being spread over a higher level of production. A change in fixed costs has no effect on marginal costs. Marginal costs relate only to variable costs! Variable Costs  Variable costs vary directly with output – when output is zero, variable costs will be zero but as production increases, total variable costs will rise  Examples of variable costs include the costs of raw materials and components, packaging and distribution costs, the wages of part-time staff or employees paid by the hour, the costs of electricity and gas and the depreciation of capital inputs due to wear and tear Average variable cost (AVC) = total variable costs (TVC) /output (Q) Total Cost (TC) = fixed costs + variable costs Average Total Cost (ATC or AC)  Average total cost is the cost per unit produced  Average total cost (ATC) = total cost (TC) / output (Q) Airline Costs – The Last Passenger is Key! In 2012 the Wall Street Journal published an investigation into the operating costs of airlines in the United States. They started their research with a simple question. On an airplane carrying 100 passengers, how many customers does it take, on average, to cover the cost of the flight? The answer reveals much about the low profit margins for many airlines and emphasizes the need for airlines to use pricing tactics to fill their planes and generate as much extra revenue as possible. On average it takes 99 paying passengers to cover all costs and that only the 100th passenger takes them into profit! Some of the key costs for an airline are:  Aviation fuel  Salaries for airline staff  Costs of buying and leasing planes  Maintenance of assets including planes  Federal taxes  Crash insurance  Compensation paid for bumped passengers or lost luggage  In-flight catering costs  Rental fees for gates & ticket counters  Landing fees  Advertising and legal fees Source: Wall Street Journal, June 2012
  19. 19. © Tutor2u Limited 2013 19 Marginal Cost  Marginal cost is the change in total costs from increasing output by one extra unit  The marginal cost of supplying extra units of output is linked with the marginal productivity of labour  The law of diminishing returns implies that marginal cost will eventually rise as output increases  At some point, rising marginal cost will lead to a rise in average total cost. This happens when the rise in AVC is greater than the fall in AFC as output (Q) increases Calculating Costs – A Numerical Example A numerical example of short run costs is shown in the table below. Fixed costs are assumed to be constant at £200. Variable costs increase as more output is produced. Output (Q) Total Fixed Costs (TFC) Total Variable Costs (TVC) Total Cost Average Cost Per Unit Marginal Cost (the change in total cost from a one unit change in output) (TC= TFC + TVC) (AC = TC/Q) 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 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 format If for example, the short-run total costs of a firm are given by the formula SRTC = $(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 = $12,500 Marginal costs of farming Farmers in the United States are facing higher marginal costs for each area of their land cultivated. According to North Dakota State University, the cost per acre in the state for wheat has surged from $2.89 in 2004 to $5.03 in 2011 due to more expensive seeds, fertilizers, fuel and labour.
  20. 20. © Tutor2u Limited 2013 20 Short Run Cost Curves  In the diagram below, when diminishing returns set in (beyond output Q1) marginal cost rises  Average cost per unit falls until output Q2 where the rise in average variable cost (AVC) equates with the fall in average fixed cost (AFC)  Output Q2 is the lowest point of the ATC curve. This is the output of productive efficiency  The marginal cost curve (MC) will cut both the average variable cost curve (AVC) and average total cost curve (ATC) at their minimum point Costs Output (Q) Average Fixed Cost (AFC) Average Variable Cost (AVC) Average Total Cost (ATC) Marginal Cost (MC) Q1 Q2
  21. 21. © Tutor2u Limited 2013 21 The Effects of an Increase in Variable Costs  A rise in variable costs of production – perhaps due to a rise in oil and gas prices or a rise in the national minimum wage - leads to an upward shift both in marginal and average total cost  The firm is not able to supply as much output at the same price  The effect is that of an inward shift in the supply curve of a business in a competitive market Showing Changes in Fixed Costs  An increase in fixed costs has no effect on the variable costs of production  This means that only the average total cost curve shifts  There is no change on the marginal cost + no change in the profit maximising price and output  The effects of an increase in the fixed costs of a business are shown in the next diagram Costs Output (Q) Average Variable Cost (AVC1) Average Total Cost (ATC1) Marginal Cost (MC1) MC2 AC2 AVC2 Costs Output (Q) AC1 MC AC2 (after rise in fixed costs)
  22. 22. © Tutor2u Limited 2013 22 Rising costs for household goods giant Unilever Unilever - the world’s second-biggest consumer-goods company – has announced that profitability might fall even after it increased prices to offset soaring costs for the commodities used to make its products. Unilever, the manufacturer of numerous household-name brands including Dove soap, Bertolli sauces, Coleman’s mustard, Vaseline, Lynx deodorant, Knorr soup, Lipton tea, Magnum ice cream and Domestos bleach has been affected by a sharp rise in the prices of ingredients, oil and packaging. It has chosen to pass on some of the rise in costs to its main customers - supermarkets and grocery stores around the world. In response the CEO of Unilever has attempt to streamlining packaging, paring logistics, sourcing and purchasing costs. A cut in overheads will also help to maintain profitability. All food companies are grappling with higher costs, Unilever is in direct competition with Proctor and Gamble, Danone and Nestle. They all have significant buying power - for example, Unilever each year buys up to 12% of the world’s black tea crop and 6% of its tomatoes. It is one of the world’s largest buyers of palm oil, which it uses in margarine and skincare products. The world price of palm oil has risen as much as 40 percent in the last year. Cost curves for businesses with fixed costs only The diagram below shows the cost and revenue curves of a monopoly producer who’s only cost of production is a fixed cost. If the marginal cost of production is zero, then total cost will stay the same as output increases. The result is that the average fixed cost curve is the same as the average total cost curve and will fall continuously as production expands. Costs Output (Q) Average Fixed Cost = Average Total Cost
  23. 23. © Tutor2u Limited 2013 23 Case Study: The Cost and Market Price of Gas High gas prices impact on millions of households whose energy bills have soared in recent years and have led to a steep increase in fuel poverty among lower-income families. A standard gas bill for UK consumers getting their suppliers from Centrica – owned by British Gas - breaks down as follows:  56% - cost of gas bought from the wholesale market  21% - cost of delivering gas to the home – including the cost of building, maintaining and operating the local gas pipes  10% - cost of obligations imposed by government such as environmental taxes plus VAT at 5%  8% - other operating costs of British Gas – including the costs of building, maintaining and operating the high pressure gas transmission networks  5% - profit for gas suppliers The average credit gas bill for a typical consumer was £836 in 2012. This was more than double the 2001 low in real terms. In 2012, Centrica earned a profit of £48 on the average UK residential dual-fuel bill of £1,188 The UK gas supply industry is an oligopoly dominated by British Gas, EDF, E.ON, Npower, Scottish Power, and Scottish & Southern. The industry watchdog Consumer Focus estimates that 6.5m UK households spend more than ten per cent of their household income on energy bills, which is defined as being in fuel poverty. Gas companies have been heavily criticised for being quick to raise their prices when gas prices on the wholesale market head higher, but delay price reductions when world prices dip.
  24. 24. © Tutor2u Limited 2013 24 5. Production in the Short and the Long Run Production Functions The production function relates the quantity of factor inputs used by a business to the amount of output that result. We use three measures of production and productivity: o Total product (or total output). In manufacturing industries such as motor vehicles and DVD players, it is straightforward to measure how much output is being produced. In service or knowledge industries, where output is less “tangible” it is 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 Function  The short run is a time period where at least one factor of production is in fixed supply  A business has chosen it’s scale of production and must stick with this in the short run  We assume that the quantity of plant and machinery is fixed and that production can be altered by changing variable inputs such as labour, raw materials and energy Diminishing Returns  In the short run, the law of diminishing returns states that as more units of a variable input are added to fixed amounts of land and capital, the change in total output will first rise and then fall  Diminishing returns to labour occurs when marginal product of labour starts to fall. This means that total output will be increasing at a decreasing rate What might cause marginal product to fall? One explanation is that, beyond a certain point, new workers will not have as much capital equipment to work with so it becomes diluted among a larger workforce. In the following numerical example, we assume that there is a fixed supply of capital (20 units) to which extra units of labour are added.  Initially, marginal product is rising – e.g. the 4th worker adds 26 to output and the 5th worker adds 28 and the 6th worker increases output by 29.  Marginal product then starts to fall. The 7th worker supplies 26 units and the 8th worker just 20 added units. At this point production demonstrates diminishing returns.  Total output will continue to rise as long as marginal product is positive  Average product will rise if marginal product > average product
  25. 25. © Tutor2u Limited 2013 25 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 Diagram to show diminishing returns as extra labour is employed Average product rises as long as marginal product is greater than the average – e.g. when the seventh worker is added the marginal gain in output is 26 and this drags the average up from 19 to 20 units. Once marginal product is below the average as it is with the ninth worker employed then the average must decline. Criticisms of the Law of Diminishing Returns  How realistic is this assumption of diminishing returns? Surely ambitious and successful businesses will 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-national businesses to source their inputs from more than one country and engage in transfers of business technology, makes diminishing returns less relevant as a concept.  Many businesses are multi-plant meaning that they operate factories in different locations – they can switch output to meet changing demand. Total Output (Q) Units of Labour Employed (L) (Q)Slope of the curve gives the marginal product of labour Diminishing returns are apparent here – total output is rising but at a decreasing rate
  26. 26. © Tutor2u Limited 2013 26 Long Run Production - Returns to Scale In the long run, all factors of production are variable. How the output of a business responds to a change in factor inputs is called returns to scale. Numerical example of long run returns to scale Units of Capital Units of Labour Total Output % Change in Inputs % Change in Output Returns to Scale 20 150 3000 40 300 7500 100 150 Increasing 60 450 12000 50 60 Increasing 80 600 16000 33 33 Constant 100 750 18000 25 13 Decreasing  When we double the factor inputs from (150L + 20K) to (300L + 40K) the % change in output is 150% - increasing returns  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%) i.e. decreasing returns  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 inputs The nature of the returns to scale affects the shape of a business’s long run average cost curve Finding an optimal mix between labour and capital In the long run businesses will be looking to find an output that combines labour and capital in a way that maximises productivity and reduces unit costs towards their lowest level. This may involve a process of capital-labour substitution where capital machinery and new technology replaces some of the labour input. In many industries over the years we have seen a rise in the capital intensity of production - good examples include farming, banking and retailing. Robotic technology is extensively used in many manufacturing / assembly industries such as cars and semi-conductors. The image on the left is of a Ford car assembly factory in India.
  27. 27. © Tutor2u Limited 2013 27 6. Long Run Costs: Economies of Scale A huge distribution centre operated by Sainsburys – with lots of different economies of scale in action! Economies of Scale  In the long run all costs are variable and the scale of production can change (no fixed inputs)  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 give a business a competitive advantage in a market. They lead to lower prices and higher profits – this is called a positive sum game for producers and consumers (i.e. the welfare of both will improve)  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 curve (LRAC) is declining, then internal economies of scale are being exploited. The table below shows a numerical example of falling LRAC 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 6
  28. 28. © Tutor2u Limited 2013 28 Returns to Scale and Costs in the Long Run The table below shows how changes in the scale of production can, if increasing returns to scale are exploited, lead to lower average costs. Factor Inputs Production Costs (K) (La) (L) (Q) (TC) (TC/Q) Capital Land Labour Output Total Cost Average Cost Scale A 5 3 4 100 3256 32.6 Scale B 10 6 8 300 6512 21.7 Scale C 15 9 12 500 9768 19.5 Costs: Assume the cost of each unit of capital = £600, Land = £80 and Labour = £200 Because the % change in output exceeds the % change in factor inputs used, then, although total costs rise, the average cost per unit falls as the business expands from scale A to B to C Examples of Increasing Returns to Scale Much of the new thinking in economics focuses on the increasing returns available to growing businesses: An example of this is the software business. 1. The overhead costs of developing new software programs or computer games are huge - often running into hundreds of millions of dollars 2. The marginal cost of one extra copy for sale is close to zero, perhaps just a few cents or pennies. 3. If a company can establish itself in the market, positive feedback from consumers will expand the installed customer base, raise demand and encourage the firm to increase production. 4. Because marginal cost is low, the extra output reduces average costs creating economies of size. Capacity Utilisation, Fixed Costs and Profits  Lower costs normally mean higher profits and increasing financial returns for the shareholders. What is true for software developers is also important for telecoms companies, transport operators and music distributors.  We find across many different markets that, when a high percentage of costs are fixed the higher the level of production the lower will be the average cost of production. Strong demand means that capacity utilization rates are high and this lowers the unit cost of supply. Long Run Average Cost Curve  The long run average cost curve (LRAC) is known as the ‘envelope curve’ and is usually drawn on the assumption of their being 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 the SRAC 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. For example a doubling of factor inputs might lead to a more than doubling of output.  Conversely, When LRAC eventually starts to rise then the firm experiences diseconomies of scale, and, If LRAC is constant, then the firm is experiencing constant returns to scale  The working assumption is that a business will choose the least-cost method of production in the long run. Moving down the LRAC means there are cost advantages from a bigger scale of operations.
  29. 29. © Tutor2u Limited 2013 29 What are the main Examples of Internal Economies of Scale? (IEoS) Internal economies of scale come from the long-term growth of the firm. Examples include: 1. Technical economies of scale: These refer to gains in productivity from scaling up production. a. Expensive (indivisible) 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. 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 (also known as 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 i. 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 over 500 passengers on long haul flights. ii. The law of increased dimensions is also important in the energy sectors and in industries such as office rental and warehousing. Amazon 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: 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”, indicate that unit manufacturing costs typically fall by between 70% and 90% with each doubling of cumulative output. LRAC SRAC1 SRAC2 SRAC3 Costs AC3 The Long Run Average Cost Curve (LRAC) AC1 AC2 Q2 Q3 Output (Q)Q1
  30. 30. © Tutor2u Limited 2013 30 2. Marketing Economies - Monopsony Power: a. 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 b. Large 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 middlemen to coffee producers in some of the poorest countries 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. The credit crunch and fragility of the banking system has made raising finance harder for businesses of all sizes – bank overdraft and loan interest rates have increased across the board, but it remains true that larger corporations can still access credit at a cheaper cost. 5. Network economies of scale: 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. Case Study: Small businesses and financial economies of scale A Bank of England survey on financial and credit conditions finds that smaller businesses are finding it tough to get the credit they need to finance an upturn in sales and production. Interest rate spreads on new loans are rising and it is larger firms that seem to be benefitting from lower borrowing costs. According to the report “larger businesses are enjoying a reduction in the cost of borrowing and improved access to credit as banks favour lower-risk custom.” The main commercial banks continue to adopt a risk-averse approach to new lending and this may hamper prospects of recovery. Unsecured loans for consumers have also become harder to get and more expensive despite the ultra-low interest rate policy of the Bank of England. In 2006, the top 10 average rate for a £3,000 personal loan was 6.49%, but today it is 14.92%, analysis by price comparison website moneysupermarket.com has shown. Source: Tutor2u economics blog, April 2010
  31. 31. © Tutor2u Limited 2013 31 What are Network Economies of Scale? The power of networks is becoming increasingly recognized in the economics of long run costs, revenues and profits. Many networks 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. Good examples to use include online auction sites such as eBay, social networking sites, wireless service providers, air and rail transport networks and businesses such as Amazon. In most cases, the marginal cost of adding one more user or customer to a 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. Given the high fixed costs of establishing a network, the more users there are the lower are the fixed costs per unit. Thus as the network expands, not only are there potential gains from extra revenues, but the long run cost per user diminishes - an internal economy of scale. In some cases an industry that requires a network to fulfill customer needs and wants across a country or region might be classified as a natural monopoly - an industry where long run average cost falls over a huge range of output and where the minimum efficient scale is a large percentage of market demand. Consider as examples the networks required by the major utilities such as water, gas, electricity and (fixed line) broadband suppliers. And perhaps businesses such as Network Rail and the Royal Mail might also claim to have aspects of a natural monopoly given the requirement for the former to maintain and improve a national rail infrastructure and, for the latter, to keep a universal postal service running to add postal addresses in the country - this is of course a loss- making aspect of their business model. Where there are strong grounds for believing an industry is a natural monopoly, there might be a case for nationalizing and/or regulating the network element of the business but introducing competition into the actual service provision - e.g. franchise bids for train operating companies, and partial or complete deregulation of parcel and letter collection, sorting and delivery. Source: Tutor2u Economics Blog
  32. 32. © Tutor2u Limited 2013 32 Analysis: Economies of Scale – The Effects on Price, Output and Profits  Consider the diagram below - scale economies allow a supplier to move from SRAC1 to SRAC2  A profit maximizing producer will produce at a higher output (Q2) and charge a lower price (P2) as a result – but the total profit is also much higher (compare the two shaded regions)  Both consumer and producer surplus has increased – there has been an improvement in economic welfare and efficiency – the key is whether these cost savings are passed onto consumers! Analysis Diagram for External Economies of Scale (EEoS) The diagram below shows the effects of external economies of scale that benefit the majority of businesses that operate in a given industry. Costs Output (Q) SRAC1 SRAC2 AR (Demand) MR MC1 MC2 P1 P2 Q1 Q2 Profit at Price P1 Profit at Price P2 Cost (Per unit of output) LRAC1 B Economies of Scale LRAC2 External Economies of Scale C A Output
  33. 33. © Tutor2u Limited 2013 33  External economies of scale occur outside of a firm but within an industry.  For example investment in a better transport network servicing an industry will resulting in a decrease in costs for a company working within that industry  Investment in industry-related infrastructure including telecommunications can cut costs for all  Another example is the development of research and development facilities in local universities that several businesses in an area can benefit from  Likewise, the relocation of component suppliers and other support businesses close to the centre of manufacturing are also an external cost saving  Agglomeration economies may also result from the clustering of businesses in a distinct geographical location e.g. software in Silicon Valley or investment banks in the City of London Case Studies in External Economies of Scale Formula One Britain has a history of providing a base for some of the most successful teams in Formula One. McLaren are based in Woking but Renault, Honda, Williams and Red Bull are all clustered in the east Midlands. Partly this is an accident of history - namely the availability of disused airfields after the war. But the cluster of F1 teams is also a good example of the external economies of scale that can be generated when a group of producers develop and expand in a relatively small geographical area. Most of the teams currently racing are based in the UK, along with their R&D operations. A whole network of industries, such as component suppliers, engineering and design firms, have sprung up in Britain, mostly in central England, to serve the sport both here and abroad. F1 also helps to support a far larger motorsport industry in the UK, for example rally car racing and all its associated industries. Estimates of the total number of jobs dependent on motorsport in the UK vary between 45,000 and 110,000. Geoff Goddard, professor in Motorsport Engineering Design at Oxford Brookes University, estimates that it accounts for 1 per cent of GDP, not insignificant when compared to car manufacturers, which represent about 5 per cent. Science Cities Science cities are knowledge clusters that bring together higher education expertise and entrepreneurial zeal. Their number continues to grow from California and Boston in the USA, Cambridge in the UK, Education City in Qatar, Science City in Zurich and Digital Media City in Seoul. In London there is much excitement about Tech City, an area around Shoreditch and Old Street in east London which is home to a growing number of technology digital and creative companies. It is also known as Silicon Roundabout and recent estimates suggest there are 3,200 firms in the area employing some 48,000 people Source: Tutor2u Economics Blog
  34. 34. © Tutor2u Limited 2013 34 Economies of Scale – The Importance of Market Demand  The market structure of an industry is affected by the extent of economies of scale available to individual suppliers and by the total size of market demand.  In many industries, it is possible for smaller firms to make a profit because the cost disadvantages they face are relatively small. Or because product differentiation allows a business to charge a price premium to consumers which more than covers their higher costs.  A good example is the retail market for furniture. The industry has major players in different 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 for bespoke furniture owing to the low price elasticity of demand for high-quality, hand crafted furniture products.  Small-scale manufacturers can extract the consumer surplus that is present when demand is estimated to have a low elasticity of demand. Economies of Scope  Economies of scope occur where it is cheaper to produce a range of products rather than specialize in just a handful of products. For example, in the competitive world of postal services and business logistics, service providers such as Royal Mail, UK Mail, Deutsche Post and parcel carriers including TNT, UPS, and FedEx are broadening the range of their services and making better use of their collection, sorting and distribution networks to reduce costs and earn higher profits from higher-profit-margin and fast growing markets.  A company’s management structure, administration systems and marketing departments are capable of carrying out these functions for more than one product.  Expanding the product range to exploit the value of existing brands is a way of exploiting economies of scope.  A good example of “brand extension” is the Easy Group under the control of Stelios where the distinctive Easy Group business model has been applied (with varying degrees of success) to a wide range of markets – easy Pizza, easy Cinema, easy Car rental, easy Bus and easy Hotel to name just a handful!  Procter and Gamble is the largest consumer household products maker in the world. Its brands include Crest, Duracell, Gillette, Pantene, and Tide, to name just 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 uses it for multiple occasions – as a coffee shop during the day and as a supper-bar and jazz room in the evenings. A computing business can use its network and databases for many different uses. Has global outsourcing peaked? Outsourcing involves passing work to a subcontractor who takes on that role. Over the past few decades companies have contracted out everything from mopping the floors to spotting the flaws in their internet security. One estimate is that $100 billion-worth of new contracts are signed every year. In Britain, 10% of workers toil away in “outsourced” jobs and companies spend $200 billion a year on outsourcing. But is it as useful as its fans claim? There are signs that outsourcing often goes wrong, and that companies are rethinking their approach to it. Recent figures suggest that the value of outsourcing contracts is falling steeply. Some of the worst business disasters of recent years have been caused or aggravated by outsourcing. Eight years ago Boeing, America’s biggest aero plane-maker, decided to hire contractors to do most of the grunt work on its new 787 Dreamliner. The result was a nightmare. Some of the parts did not fit together. Some of the dozens of sub-contractors failed to deliver their components on time, despite having sub-contracted their work to sub-sub-contractors. Sometimes companies squeeze their contractors so hard that they are forced to cut corners. Vendors may overpromise in order to win a contract and then fail to deliver. And service companies, contract out customer complaints to foreign call centres and then wonder why their customers hate them. When outsourcing goes wrong, it is hard to put right.
  35. 35. © Tutor2u Limited 2013 35 Key global trends affecting business strategies A new report by consultants Ernst & Young examines six broad, long-term developments which shape business around the globe. In summary, the six trends are: (1) Emerging markets increase their global power (2) Cleantech becomes a competitive advantage (3) Global banking seeks recovery through transformation (4) Governments enhance ties with the private sector (5) Rapid technology innovation creates a smart, mobile world (6) Demographic shifts transform the global workforce The Importance of Minimum Efficient Scale (MES)  The minimum efficient scale (MES) is the scale of output where the internal economies of scale have been fully exploited.  MES corresponds to the lowest point on the long run average cost curve and is also known as an output range over which a business achieves productive efficiency.  MES is not a single output level – more likely, the MES is a range of outputs where the firm achieves constant returns to scale and has reached the lowest feasible cost per unit. The minimum efficient scale depends on the nature of costs of production in a specific industry. 1. How many firms can "fit" in a market? It depends on the size of the market compared to the size of the minimum efficient scale 2. In industries where the ratio of fixed to variable costs is high, there is 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 3. 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! 4. 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. Costs Revenues Output (Q)MES LRAC Increasing return to scale – economies of scale - falling LRAC Decreasing returns – diseconomies of scale
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  37. 37. © Tutor2u Limited 2013 37 7. Diseconomies of Scale Diseconomies are the result of decreasing returns to scale and lead to a rise in average cost Diseconomies of scale in a large business may be due to: 1. Control – monitoring the productivity and the quality of output from thousands of employees in big, complex corporations is imperfect and expensive – this links to the concept of the principal-agent problem i.e. the difficulties of shareholders monitoring the performance of managers. 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 Big organizations often suffer from the debilitating effects of internal politics, information over-load, complex bureaucracy, unrealistic expectations among managers and cultural clashes between senior people with inflated egos. The result can be that hidden costs increase quickly – expense accounts, a slump in productivity, a deadweight loss of time in slow-moving big businesses. This is the essence of diseconomies of scale. Avoiding diseconomies of scale 1. Human resource management (HRM) focuses on improvements in recruitment, communication, 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. 2. Performance related pay schemes (PRP) can provide financial incentives for the workforce leading to an improvement in industrial relations and higher productivity. 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. Each partner gets a share of the firm’s profits each year, 3. 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. Fundamentally the best way to avoid diseconomies of scale is to make business organization less complex and more transparent. Nokia, diseconomies of scale and lost competitive advantage Nokia is a Finnish conglomerate business that turned itself into the world’s leading mobile phone company in the 1990s. Nokia is profitable, but revenues are under pressure and in 2010, Nokia appointed a new CEO - Stephen Elop - to drive strategic change In February 2011 - Elop issued the famous “burning platform” memo bluntly explaining the strategic challenges facing Nokia. Elop announced a strategic partnership with Microsoft to jointly- develop smart phones using the Windows mobile platform - ditching Nokia’s investment in its homegrown Symbian platform Nokia had missed the major change in its market - the Smartphone revolution. It had continued to focus on mobile phone devices (hardware) rather than applications (software). The consumer transition from traditional mobile phones to smart phones has been dramatic and caught Nokia off-guard. According to Elop "There is intense heat coming from our competitors, more rapidly than we ever expected. Apple disrupted the market by redefining the Smartphone and attracting developers to a closed, but powerful ecosystem.” Nokia has also faced intense competition from mobile phone producers in emerging markets who can make fast, cheap handset. At the same time there was recognition within the business that diseconomies of scale were hurting its competitiveness. Many in Nokia regretted that the business had become too product-led rather than customer-led. It was felt that the business lacked innovation with an overly-bureaucratic organisational structure with poor accountability.
  38. 38. © Tutor2u Limited 2013 38 Case Study: Amazon – Economies of Scale and Scope and Market Power 1. Increased dimensions: Firstly, the company invested in enormous warehouses to stock its inventory of books, DVDs, computer peripherals. This allows it to benefit from the law of increased dimension. 2. Buying power: Amazon has significant monopsony power when it purchases books directly from publishers, thereby bypassing its reliance on wholesalers and giving it a higher profit margin. 3. Learning by doing and first-mover advantage: The unit costs of production tend to 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 4. Pre-Orders - Amazon use a pre-order system for customers that allows it to capture early demand and improve stock (or inventory) forecasting. 5. Less invested capital: As an online retailer, Amazon avoids the need for retail stores – one advantage is that it has lower invested capital in the business and it frees up resources for customer fulfillment and investment in new technology – Amazon distributes to over 200 countries. 6. Shifting stock at speed: Amazon has a much faster stock velocity – measured by the number of weeks an item remains in stock. For Amazon this is half that of a physical store – and the benefit is a reduction 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 looking to create economies of scope from marketing and broadening the range of products available through the Amazon brand. Among the innovative business ideas under development we can identify:  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  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.
  39. 39. © Tutor2u Limited 2013 39 8. Profits The Nature of Profit  Profit measures the return to risk when committing scarce resources to a market or industry  Entrepreneurs organise factors of production and take risks for which they require an adequate rate of return.  The higher the market risk and the longer they expect to have to wait to earn a positive return, the greater will be the minimum required return that an entrepreneur is likely to demand  Economists distinguish between different types of profit: Normal profit  Normal profit is the minimum 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 put £200,000 of savings into a new business, those funds could have earned a low-risk rate of return by being saved in a bank account. You might use the rate of interest on that £200,000 as the minimum rate of return that you need to make from your investment  Because we treat normal profit as an opportunity cost of investing financial capital in a business, we include an estimate for normal profit in the average total cost curve, thus, if the firm covers its AC then it is making normal profits. Sub-normal profit - profit less than normal (P < average cost) Abnormal profit  Any profit achieved in excess of normal profit - also known as supernormal profit. 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 successfully block the entry of new firms Calculating Economic Profit The data below is for an owner-managed firm for a given year  Total revenue £320,000  Raw material costs £30,000  Wages and salaries £85,000  Interest paid on bank loan £30,000  Salary the owner could have earned elsewhere £32,000  Interest forgone on capital invested £20,000 In a simple accounting sense, the business has total revenue of Spotify reaches the Break-Even Point Founded in 2006 and launched in 2008, it has taken five years for online music business Spotify to travel from the point of concept to break-even. Spotify has grown using the “Freemium” model whereby a user-base is built by offering a basic service for free. Revenues are then built by offering paid-for premium services to customers. With Spotify, users can register either for free accounts supported by advertising or for paid subscriptions without ads and with a range of extra features such as higher bit rate streams and offline access to music. A paid “Premium” subscription is required to use Spotify on mobile devices. BSkyB Announces Record Profits BSkyB has announced record revenues and profits. Total revenue in the last year grew by 7% to reach £7,235m and operating profit was 9% higher at £1,330m. This gave the business an operating margin of 18.4% and helped the business to generate free cash flow of just over £1 billion. Revenue per subscriber increased by £29 to £577. BSkyB has 11.2 million customers. Programming costs were 34% of sales revenue at £2,486m. Sky paid £59m in the last year for the right to offer live coverage of the Ryder Cup, the Lions Tour and Formula 1. It has also invested more than £55m this year in original comedy and drama.
  40. 40. © Tutor2u Limited 2013 40 £320,000 and costs of £145,000 giving an accounting profit of £175,000. But profit according to an economist should take into account the opportunity cost of the capital invested and the income that the owner could have earned elsewhere. Taking these two items into account we find that the economic profit is £123,000. Accounting Profit and Economic Profit Short Run Profit Maximisation Profits are maximised when marginal revenue = marginal cost Price Per Unit (AR) (£) Demand / Output (units) Total Revenue (TR) (£) Marginal Revenue (MR) (£) Total Cost (TC) (£) Marginal Cost (MC) (£) Profit (£) 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 13 142 Consider the example in the table above. As price per unit declines, so demand expands. Total revenue rises but at a decreasing rate as shown by the column showing marginal revenue. Initially the firm is making a loss because total cost exceeds total revenue. The firm moves into profit at an output level of 57 units. Thereafter profit is increasing because the marginal revenue from selling units is greater than the marginal cost of producing them. Consider the rise in output from 69 to 75 units. The MR is £13 per unit, whereas marginal cost is £9 per unit. Profits increase from £142 to £166. But once marginal cost is greater than marginal revenue, total profits are falling. Indeed the firm makes a loss if it increases output to 93 units. Accounting Profit Accounting Cost Total Revenue Economic Profit = abnormal Profit Normal Profit = Opportunity Cost Accounting Cost Economic Cost
  41. 41. © Tutor2u Limited 2013 41 Showing profit maximisation in a diagram – the importance of marginal revenue and marginal cost As long as marginal revenue > marginal cost, total profits will be increasing (or losses decreasing). 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 maximising price (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 Profits are decreasing when MR < MC Marginal Revenue Marginal Cost Q1 Revenue And Cost Output (Q) Profits are increasing when MR > MC Marginal profit: the increase in profit when one more unit is sold or the difference between MR and MC Costs Revenue Output (Q) AR (Demand) MR SRMC Q1 P1 AC1 Supernormal profits at Price P1 and output Q1 AC2 Q2 Normal profit at Q2 where AR = AC SRAC
  42. 42. © Tutor2u Limited 2013 42 The Short Run Supply Decision - The Shut-down Price A business needs to make at least normal profit in the long run to justify remaining in an industry but in the short run a firm will continue to produce as long as total revenue covers total variable costs or price per unit > or equal to average variable cost (AR = AVC). This is called the short-run shutdown price. The reason for this is as follows. A business’s fixed costs must be paid regardless of the level of output. If we make an assumption that these costs cannot be recovered if the firm shuts down then the loss per unit would be greater if the firm were to shut down, provided variable costs are covered.  Average revenue (AR) and marginal revenue curves (MR) lies below average cost, 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 distance AC. No contribution is made to fixed costs  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 long run the shut down price is where AVC=P because all cost are variable Recession and factory closures  The concept of the shutdown point has become topical due to the recession and the weak subsequent recovery  Many businesses have opted to close down loss-making production plants and retailers have announced the closure of retail outlets in a bid to cut their losses.  Some of the plant closures have been temporary, for example some high-profile car manufacturers mothballed their factories and reduced the number of shifts. But for other businesses, the downturn brought about an end to trading. We have seen the demise of a large number of well-known retail businesses. Costs, Revenues Output (Q)Q1 MC AVC AR MR P1 AC1 A B C P1 is below average variable cost - staying in production means that losses would increase. P2 ATC
  43. 43. © Tutor2u Limited 2013 43 Blockbuster goes bust The US parent company of the Blockbuster rental company has gone into bankruptcy. In the early days of the internet, it was thought that a High Street presence was important to complement trading via the internet. But Blockbuster has gone, and so have Barnes and Noble. Meanwhile, Love Film and Amazon continue to grow at a rapid rate. So a place on the High Street can’t be essential. Is it even desirable? Blockbuster might yet last a while in the UK (where it continues as a franchise set up). But in the US the business was trapped by two competitors. One force is the online competitor Netflix and the other was Redbox which rents films for one dollar a night through kiosks in convenience stores. Netflix has a vast selection of DVDs and is promoting the online streaming of older films, which subscribers will increasingly be able to obtain through internet-connected television sets. Redbox, in contrast, focuses on big films and recently-released DVDs which it rents out from vending machines for $1. Blockbuster was crushed in the middle. Source: Tom White, Tutor2u Analysis: Deriving the Firm’s Supply Curve in the Short Run 1. In the short run, the supply curve for a business operating in a competitive market is the marginal cost curve above average variable cost. 2. In the long run, a firm must make a normal profit, so when price = average cost, this is the break- even point. It will therefore shut down at any price below this in the long run. 3. 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 is a price- maker, not a “passive” price-taker, and can thus select the price and output combination on the demand curve so as to maximise profits where marginal revenue = marginal cost. Analysis: Using Diagrams to show the effects of Changes in Demand and Supply Conditions  A change in demand and/or costs will lead to a change in the profit maximising price and output.  In exams you may often be asked to analyse how changes in demand and costs affect the equilibrium output for a business. Make sure that you are confident in drawing these diagrams and you 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 short run costs of production remain unchanged). The increase in demand causes a rise in the price from P1 to P2 (consumers are now willing and able to buy more at a given price) and an expansion of supply (the shift in AR and MR is a signal to firms to move along their marginal cost curve and raise output). Total profits have increased