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Growth of Firms
In this note we consider the different ways in which businesses can grow. We consider in particular the difference between organic and external growth. Motivations for the growth of businesses The following factors are commonly associated with the desire of firms to grow: 1. The profit motive: Larger scale enterprises grow to expand output and achieve a higher level of profit. The stimulus to achieve year-on-year growth is often provided by the demands and expectations placed on a business by the capital (stock) markets. The stock market valuation of a firm is heavily 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 a company’s market capitalisation. Falling share prices increases the risk of a hostile take-overand also makes it harder and more expensive for a quoted company to raise fresh financial capital by issuing new shares onto the market. 2. The cost motive: Economies of scale have the effect of increasing the productive capacity of the business and they help to raise profit margins. They also give a business a competitive edge in domestic and international markets. 1. The market power motive: Firms may wish to grow to increase their market dominance thereby giving them increased pricing power in specific markets. Monopolies for example can engage in price discrimination. 2. The risk motive: The expansion of a business might be motivated by a desire to diversify production and sales so that falling sales in one market might be compensated by healthier demand and output in another market. 3. Managerial motives: Behavioural theories of the firm predict that the growth of a business is often spurred on by the decisions and strategies of managers employed by a firm whose objectives might be different from those with an equity stake in the business. Organic and external growth of a business Organic growth Case Study: Growing a business organically – Caffe Nero Caffe Nero, which began with five stores in 1997, is the third-largest coffee bar chain in the country behind Whitbread-owned Costa Coffee and Starbucks. The business has based its strategy on a programme of opening new stores on a regular basis. Each year a number of new stores are opened and some are closed, but the net number of new stores is positive. Caffe Nero now generates sufficient cash to fund an opening programme of 40 - 50 stores without recourse to external funding such as fresh bank loans or the issue of corporate bonds. Caffe Nero is the thirdlargest UK branded coffee bar chain, as measured by outlet numbers. It now trades from 230 bars and is expanding at a rate of close to 40 new bars a year. The performance of the business is impressive: Turnover has risen from £26.6m in 2002 to £70.1m in 2005. The business generates a strong cash flow and high operating profit which in turn allows it to finance the opening of new stores without having to borrow money. Caffe Nero is achieving like for like sales growth faster than its major competitors in the market and it serves over 750,000 ABC1 customers every week, and has a strong brand reputation in highly competitive market place.
Monopoly power can of course come organically through internal growthwhere a firm takes advantage of economies of scale. The deal makes Tesco the latest in a long line of British companies — including Emap. Monopoly power can also come from winning bidding races for exclusive agreements – the best example of which is probably the monopoly on broadcasting live soccer games on TV owned by BSkyB as a result of winning auctions organised by the Premier League. Starbucks Costa Coffee Costa Coffee External growth of a business Food Quality Price/Value Caffe Nero Caffe Nero Starbucks Costa Coffee Costa Coffee Starbucks How does a firm establish and then protect a monopoly position? The fastest route to take an increasing share of a market is through integration i. distribution and retail subsidiaries. The government and its agencies may also give legal monopoly power to some business throughfranchises and licences. De Beers – diamonds). o Monopoly power also comes from owning patents and copyright protection or the exclusive ownership of productive assets (e. o Horizontal integration: Horizontal integration occurs 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. Costa Coffee Starbucks Starbucks 3. through mergers or contested take-overs. Caffe Nero Caffe Nero Caffe Nero 2. The contested bid for Safeway by Morrisons and other leading retailers is another example of the process of horizontal integration. External growth – joint ventures Tesco expands into China Tesco plans to become the first British supermarket group to enter the booming Chinese food retail market. the biggest food producer in China. According to Tesco. Over 30% of UK companies now do some of their production .Allegra Consumer Report 2005 . Vertical integration: Vertical Integration involves acquiring a business in the same industry but at different stages of the supply chain – for example an oil company that owns drilling and extraction businesses together with refining.e. Tesco is buying a 50 per cent stake in the 25-strong Hymall hypermarket chain from Ting Hsing. Prudential and WPP — to seek business opportunities in China where economic growth has averaged nearly ten per cent per annum in recent years. which already have a presence in the communist state. ―China is one of the largest economies in the world with tremendous forecast growth" Suggestions for further reading: Tesco investor relations Articles on Tesco on BBC news online Outsourcing The tendency of companies to outsource some of their production operations overseas has become an important issue in recent years. It has announced a £140 million deal that could transform the company into the world’s biggest grocer.Major Coffee Brands Service Rank Coffee Quality Atmosphere Quality 1.g. The deal gives Tesco the opportunity to take on the likes of Wal-Mart and Carrefour. Kingfisher. the world’s two biggest retailers.
Abbey National. Call centre staff in India can expect an equivalent salary of around £1200 and with that comes the status of a junior doctor or a lawyer. Many of the major personal computer businesses such as HP-Compaq. Services are increasingly footloose. 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". Dell and IBM outsource PC production. And its Swedish rival. The Dutch telecoms business Philips has outsourced much of its handset production to a joint venture which the Dutch electronics company has in China. Finland’s Nokia. whilst keeping their research and design operations in the UK. Ericsson. especially new products.which increases the pressure on businesses to achieve lower unit costs as a means of maintaining market share 3. The contractors engaged in manufacturing can also gear themselves up to exploit much greater technical economies of scale because they make similar products for other customers. Pressure from the financial markets for businesses to improve their profitability For many large businesses. The survival of smaller businesses in the economy Over time there is a clear trend towards larger scale business operations partly because of the pressures of competition.the average price of a one minute international call was 74% lower in 2003 than in 1993 2. the need to achieve economies of scale and the effects of mergers and .000 UK service sector jobs could be lost within the next five years. In recent times we have seen Norwich Union. Technological change – Information. Tesco. There are though some risks involved. there are clear cost advantages to be gained through doing business via a call centre located overseas. Increased competition in a low-inflation environment . Communication costs are dropping sharply . British Airways and National Rail Enquiries all transfer significant parts of their operation overseas. One of the longer term benefits of sub-contracting manufacturing to other companies is that a business can then concentrate on marketing their products and investing in research and development to develop new products through product innovation. First mover advantages are being recognised (i. providing greater flexibility of production levels at times of volatile demand and also in speeding up the time it takes to get their goods to market. Outsourcing is not simply confined to service sector industries. Dyson is a high profile example of a company that has relocated production abroad to Malaysia.e. has transferred all of its mobile-phone production to a contractor in Singapore. communication and telecommunication costs are falling . Offshore relocation makes sense when it is part of a strategy for growth that protects the long term interests of the business. The Sunday Times has recently speculated that up to 200. If it is merely a cost cutting reaction to competition then it is a survival strategy.work abroad. whilst 10% have over half of their manufacturing offshore in lower cost locations. the world’s largest cell phone maker now outsources 20% of its handset production. Many manufacturing businesses are using outsourcing as a means of reducing their costs. Businesses need to be confident that their contractors can guarantee to meet required production levels. Most recently we are witnessing an accelerated trend for service sector businesses to follow suit. There are three main drivers promoting outsourcing as a business strategy: 1.this makes it much easier to outsource both service and manufacturing operations to sub-contractors in other countries. and can order components in larger numbers to achieve some financial scale economies. there are advantages in re-locating first) and a snowballing effect is now in evidence.
would not even consider trying to create a monopoly position for themselves: it would simply be too expensive when one considers the diseconomies of scale that would result. The most striking was to illustrate this point is to look at Japan. It is no coincidence that Japanese business is dominated by six or seven keiretsu. I believe that the reason that small firms can survive in even the most competitive markets because they are allowed to. And even in industries where giant businesses dominate the market place. and while some lambaste the mercantile attitude of these firms. This is mainly due to do with the fact that there is no market where a firm can achieve a minimum efficient scale that meets 100% of its demands. This status quo seems bizarre to those of us from Western economies focussed on the bottom line.takeovers across many industries. There are plenty of examples where businesses are de-merging and divesting themselves of some of their existing assets. Two examples would be a political risk insurance broker for investments in emerging markets or a hedge fund specialising in increasing shareholder value through managerial restructuring. costs would begin to increase as the firm encounters diseconomies of scale. There are several large players – Citigroup. Bank of America. Despite its attempts to become all things to all people (―Waitrose quality at Asda prices‖ as one advertising campaign puts it). Take the petroleum industry: even if Royal Dutch-Shell or Chevron or BP were operating at maximum efficiency. even the biggest US corporations are limited by our business mentality. or even ―satisficing‖. Businesses in Japan focus on market share rather than revenues or profits. with the lowest possible long run average costs. However. While firms that exploit economies of scale and can become major players in an industry as a whole. firms that are profit or revenue maximising. It is worth further analysing exactly why it would be prohibitively expensive for larger corporations to squeeze smaller businesses out of the market in an effort to dominate it. firms that operate on a large scale and can thereby maximise the potential of economies of scale and scope. including the biggest ones. that output would only meet 15% of the market’s demand for petrol. However. They are willing to sustain huge losses in the short term in order to gain a market share that will create greater profits in the long run. AIG. it is what makes a diverse market possible. The most striking evidence of this is the fact that there are no pure monopolies in the world today. HSBC. Why do small businesses continue to thrive despite the prevalence of economies of scale and multinational businesses in many markets and industries? It is incontestable that nowadays. there is always room for countless small firms to find a niche in which they can perform better than any other firm. where it just . Both of these are highly specialised fields. there is frequently room for smaller firms to compete and survive profitably. Take the supermarket sector: in Britain at the moment there exists an oligopoly dominated by Tesco. However the process towards big business size is not purely a one-way street. While it is nigh on impossible to compete with the keiretsu in Japan. Therefore. If any one of these companies tried to expand output to try and take a greater market share. it will simply not be able to corner every market: the cost of establishing a Tesco store wherever there are customers is not feasible. the market will not allow Tesco to become the only retailer of food (and certainly not the only retailer of insurance or financial services). Merrill Lynch and JP Morgan to name a few) – however there also exist myriad small businesses that have a niche (often very obscure) in which they can perform better than anyone else. economic realities also mean that amidst the big firms there are small businesses competing in the same markets and industries. as well as intervention by the government. One cannot ignore the impact of specialisation and quality. Indeed there are worries that Tesco is on the road to having an unfair handle on the market. super-corporations like Mitsubishi that have dealings in almost every industry. and perhaps even revenues begin to drop as collateral of an attempt to dominate the market. This would be unacceptable to shareholders as they began to see profits. A great example of this is in the financial services industry.
e.isn’t worth it for the larger firms to establish themselves.a considerable achievement for a business that rarely advertises on TV. one year after it first entered the top 100 of the annual brand survey. Pepsi Adapted from the Guardian. Conventional brand-building wisdom states that selling a product to an entire country. only eight years after it was set up in a California garage Google now outranks Sony. The $117bn (£63bn) business is ranked 24th by Interbrand. Google's brand is worth $12.by not bothering to advertise at all and relying on the global span of the internet to spread the Google word. that can not necessarily be answered by large firms capable of exploiting economies of scale. the brand consultancy. The continued survival of small firms in markets where large firms might dominate is caused by the structure of the market itself (i. According to the survey. November 2005 The growth of firms – the importance of the brand Google is challenging Coca-Cola and Microsoft for global fame after becoming the fastest growing brand in the world. the fall in performance associated with expanding production due to economies of scale) and factors such as such as demand for specialised or high-quality product. MTV and Reuters in terms of worldwide renown.4bn to the company . according to Interbrand. Source: Max Dewez. requires considerable investment in advertising campaigns. July 2006 and from the Inter-Brand web site . Google appears to have dodged the old axiom about advertising 50% of it is wasted. sponsorship and public relations. Coca-Cola holds on to number one with a brand value five times larger than Google's and its closest rival. let alone the world. but no one knows which 50% . radio or billboards.
Major privatisations The major privatisations in the UK over the last twenty five years have occurred with the following businesses (the year of privatisation is in parenthesis).) and electricity transmission company." British Rail (privatised in stages between 1994 and 1997) British Steel (1988) – British Steel merged with the Dutch steel producer Koninklijke Hoogovens to form Corus Group on 6 October 1999 British Telecom (1984) Cable and Wireless National Power and PowerGen (1990) . In the UK the process has led to a sizeable reduction in the size of the public sector of the economy.5% of total employment. .In August 1998. National Grid Company.1990 the Central Electricity Generating Board was split into three generating companies (Powergen. We look briefly at some of the issues involved in transferring assets from the public to the private sector of the economy. UK Coal’s assets were merged with RJB Mining to form UK Coal plc British Gas (1986) . The focus has switched tobreaking up existing statutory monopoly power through a process of deregulation and liberalisation of markets – basically designed to introduce competition where once monopoly power was well established. What is privatisation? Privatisation means the transfer of assets from the public (government) sector to the private sector. in Britain it is used by Centrica. British Petroleum merged with the Amoco Corporation (Amoco). Privatisation has become a common feature of microeconomic reforms throughout the world not least in the transition economies of Eastern Europe as they have made progress towards becoming fully-fledged market economies.A2 Markets & Market Systems Privatisation & de-regulation Privatisation became one of the most significant microeconomic policies of the 1980s and 1990s.In 1997 British Gas plc de-merged Centrica plc and renamed itself BG plc (later BG Group plc). More recently the privatisation process has become more complex. State-owned enterprises now contribute less than 2 per cent of GDP and less than 1. Regional water companies The early examples of privatisation such as the sale of British Telecom to the private sector in 1984 represented a simple transfer of ownership as shares were offered for sale via the stockmarket. while in the rest of the world it is used by BG Group British Petroleum . forming "BP Amoco. Associated British Ports (1983) British Aerospace (1980) – eventually merged with Marconi Electronic Systems British Airports Authority (1986) British Airways (1987) British Coal (1994) – in 1994. National Power and Nuclear Electric plc.
which is provided by Royal Mail. The Royal Mail retains a universal service commitment. but not the rolling stock. level crossings and most stations. owned by the British government. Privatisation was also seen as a way of reducing trade union power and encouraging an increase in capital investment as businesses were now free to raise extra financial capital through the stock market. The main economic arguments against privatisation Opponents of privatisation argued that state owned enterprises had already faced competition when part of the public sector and that in several instances the transfer of ownership merely replaced a public sector monopoly with a private sector monopoly.Market forces have been introduced in social services. The Royal Mail .Network Rail is a "not for dividend" company that owns the fixed assets of the UK railway system that formerly belonged to British Rail. tunnels. This means that everyone . What remains of the public sector? Privatisation has radically reduced the size of the public or government sector of the economy although since the current Labour government came to power. railway tracks. the mail market opened to full competition. each working day. Postcomm will protect the universal service.if they have been licensed by Postcomm .act as postal operators and collect. bridges. See this company profile. signals. which was in "Railway Administration". The argument is that extra competition in markets will lead to reductions in price levels for consumers and improvements over time in dynamic efficiency. as well as collections and deliveries for every address in the country. Network Rail took over ownership by buying Railtrack plc. Delivering competition On 1st January 2006. Network Rail owns the infrastructure itself. The Royal Maul is regulated byPostComm which has the power to grant licences to new competitors entering the deregulated market for household and business mail services. for £500 million from Railtrack Group plc.no matter where they live .Royal Mail has been a state-owned company since 1969 and remains a public limited company wholly owned by the UK government. in part the result of a large rise in government spending on the national health services. The following businesses remain part of the public sector: British Nuclear Fuels plc . sort and distribute mail in the UK. there has been a huge rise in total public sector employment. The universal service also includes the "one price goes anywhere" stamp. the now-defunct British stateowned railway operator. concerned with nuclear power. the NHS and in higher education. This means that organisations other than Royal Mail can now .an international company. Network Rail . There were criticisms that state assets were sold off by the government at too low a price and that .will continue to enjoy an affordable daily delivery. The market was opened up to full competition in January 2006. Source: Adapted from the PostComm website The main economic arguments for privatisation and deregulation Supporters of privatisation believe that the private sector and the discipline of free market forces are a better incentive for businesses to be run efficiently and thereby achieve improvements in economic welfare.
the liberalisation of household mail services and financial deregulation affecting both banks and building societies. there are macroeconomic implications for example an increase in an economy’s underlying trend rate of economic growth which might contribute to an improvement in average standards of living Has rail privatisation been successful? Utility regulators Utility regulators oversee the activities of companies privatised over the last two decades. if product markets become more competitive and investment flows into these industries. The Single Market seeks to promote four freedoms – namely the free movement of goods. Product market liberalisation involves breaking down barriers to entry in industries and making them more contestable.the consequences of privatisation has been a decrease in investment and large scale reductions in employment as privatised businesses have sought to cut their operating costs. In the long term. The expansion of the European Single Market has accelerated the process of market liberalisation. investment and productivity leading to a rise in economic efficiency. bring down prices for consumers. financial capital and labour. The main aims of the regulators have been to create and simulating the disciplines that . These former state-owned utilities are regulated to ensure that they do not exploit their monopoly position. Examples of this in the UK include the opening up of markets for household energy supplies. Deregulation of markets Another important policy in industries where welfare and efficiency might be affected by the dominant market power of some suppliers is to open up markets and encourage the entry of new suppliers – a process called de-regulation of product markets. and encourage an increase in competition. The aim is to boost market supply. services. In the long term we can expect to see the microeconomic effects of the EU Single Market working their way through many British markets and the general expectation is that competitive pressures for all businesses working inside the European Union will continue to intensify.
setting a price cap. firms are able to bring down their unit labour costs) . those with disabilities and on low incomes Ofgem is funded by the energy companies who are licensed to run the gas and electricity infrastructure. wherever appropriate. and regulating effectively the monopoly companies which run the gas pipes and the electricity wires Ofgem seeks to help secure Britain’s energy supplies by promoting competitive gas and electricity markets . Price-capping is an alternative to rate-of-return regulation. This takes the rate of inflation.The Office of Gas and Electricity Markets is the government regulator for the electricity and downstream natural gas markets in Great Britain. particularly older people. as regulators may end up making implicit decisions on the acceptable real rates of return on capital employed in order to arrive at price limit determinations. In the UK.e. Source: Adapted from the Wikipedia web site Price capping has meant in most cases that average prices for consumers have fallen in real terms although this has not been the case for all privatised industries.and regulating so that there is adequate investment in the networks A further role of Ofgem is to help and encourage the gas and electricity markets and industry achieve environmental improvements as efficiently as possible take account of the needs of vulnerable customers. the thrust of regulation has been to encourage competition by easing the entry of new suppliers and making markets more contestable. in which utility businesses are allowed to achieve a given rate of return (or rate of profit) on capital. Inn reality. The assumption is that productivity growth will help to accommodate the price caps. The roles of an industry regulator – the case of Ofgem Ofgem seeks to protect consumers by promoting effective competition. the distinction between price-cap and rate-of-return regulation may be lost. Ofwat – (water services regulation authority) – Ofwat is the body responsible for economic regulation of the privatised water and sewerage industry in England and Wales. In practice. the problems of leaks and rising water bills. where K is based on capital investment requirements designed to improve water quality and meet EU water quality standards. Office of the Rail Regulator – ORR is the UK government's agency for regulation of the country's railway network. measured by the Consumer Price Index and subtracts expected efficiency savings X. Its primary duty is to ―promote choice and value for all gas and electricity customers". This has meantincreases in the real cost of water bills for millions of households in the UK. Ofcom . price capping has been known as "RPI-X". In the long run. Key issues for Ofwat at the moment include the threats of water shortages. In the water industry.X + K". Profits for utilities can rise providing that efficiency levels improve (i. Adapted from the Ofgem web site Price Capping for the Utilities Price capping has been a dominant feature of regulation in recent years – although this is now being phased out as most utility markets become more competitive.companies would experience inside a competitive market. Basics of price capping Price-cap regulation is a form of intervention in the price mechanism which has been applied at various points in time to all of the privatised utility businesses in the UK. the industry regulator usually has in mind a ―satisfactory rate of return on capital employed‖ for each business.The Office of Communications is the UK's communications regulator Ofgem . the formula is "RPI .
Yell is subject to a yearly price cap of RPI less 6% . In June 2006 it was announced that Yell would still be subject to a price capping formula because of the relative absence of competition in the industry. the real cost of advertising rates are falling year-on-year. According to the Competition Commission report.Arguments for and against price-capping for the utilities Advantages Capping is an appropriate way to curtail the monopoly power of ―natural monopolies‖. . Fare changes are announced by the Association of Train Operating Companies. the train operating businesses have increased those fares that are unregulated by more than inflation. partly because they have to high fees to Network Rail for access to the track and infrastructure and because they have been making a contribution towards improvements to rail safety. advertisers would pay more than in a well-functioning market. At present. The price capping system is a useful tool for controlling consumer price inflation in the UK. Yell and price capping Price capping is still used in the market for telephone directories where Yell has a dominant positionin the market. Prices are capped at the moment and without this price cap. PostComm approves a rise in the price of stamps Stamp prices rose in April 2006 under a compromise deal between regulator Postcomm and the Royal Mail. Cuts in the real price levels are good for household and industrial consumers (leading to an increase in consumer surplus and higher real living standards in the long run).so at the moment. o Disadvantages Price caps have led to large numbers of job losses in the utility industries. First class stamps would rose 2p to 32p and second class stamps by 1p to 22p. Price capping helps to stimulate improvements in productive efficiency because lower costs are needed to increase a producer’s total profits. Setting different price capping regimes for each industry distorts the working of the price mechanism. Despite continuing high levels of government subsidy. with the possibility of them rising to 36p and 25p respectively by 2010. "Yell continues to hold a powerful position in this market and competition is not working effectively. The Royal Mail had wanted to push stamps up to 39p and 27p to help pay for capital investment and to plug a £4bn hole in its pension fund. Adapted from the BBC news website. November 2005 The rail industry was privatized between 1994 and 1997 and since then the average price of a rail fare has risen faster than inflation.
Local loop unbundling is the process of allowing telecommunications operators to use the telephone connections from the telephone exchange's central office or exchange to the customer premises be it a household or a business location. The vast majority of households are within one mile of their local telephone exchange. Although local look unbundling has taken time to become widespread. The authorities also want to encourage free transfer for consumers between suppliers (by monitoring and enforcing the nature of supply contracts) and keeping a close eye on anticompetitive behaviour. and Orange have increased . In telecommunications. The main focus of the regulatory authorities is now to provideimproved price information for consumers to make prices of different suppliers more transparent to improve the flow of information in the market. one key decision made eventually by Ofcom was to enforce unbundling of the local loop. In the UK this has meant opening up the telephone exchanges owned by British Telecom and allowing broadband businesses such as AOL-UK and Tiscali to put in their own equipment and then supply broadband services in direct competition with BT to households.Changing Role of the Utility Regulators Gradually the main utility regulators have withdrawn from price regulation because of the increased degree of competition in the market. Unbundling the local loop allows rivals to take market share British Telecom has announced that it has lost half a million residential phone lines to competitors as broadband operators such as Talk Talk. from Carphone Warehouse. it has been one factor behind the rapid expansion of market supply in broadband which is revolutionising the UK telecommunications market.
After 22 years of having its prices controlled directly by an industry regulator. the water industry is a good example of this. There remain controversial issues about the size of the profits that some of the privatised utilities are making. rather a superficial change. BT's wholesale unit can cut the price of wholesale broadband and its retail business will be better able to compete for customers. When 1. The performance of the privatised companies has been patchy. LLU allows rival firms to place equipment in BT's exchanges and transfer customers to their networks.their investment in local loop unbundling (LLU). Most of them have seen their monopoly powers eroded as their markets have become more contestable. Ofcom withdrew all price capping controls on British Telecom. Summary comments on privatisation Privatisation has changed the face of the British economy over the last twenty five years. Some privatisations have not worked. or because of the effects of wider international changes such as the process of globalisation. this marked an important milestone in the privatisation and market liberalisation process. And real price levels have come down over the longer term growth . Over twenty businesses have been transferred from the public sector to the private sector and many remaining state sector enterprises are now subject to the disciplines of the market. In most utility markets there is now genuinely more choice for consumers. The transfer of ownership from one part of the economy to another has been. the most obvious example being the failure of rail privatization and the eventual collapse of Railtrack when it went into administration. in many cases. The more fundamental changes have occurred when monopoly powers have been broken down either because of regulators legislating to open up the market. July 2006 One of the consequences of the greater level of competition in the telecommunications industry in the UK is that in July 2006. Source: Adapted from the Guardian web site.5m lines are unbundled.
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