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Business Economics

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Business Economics

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The Growth of Firms

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The Growth of Firms
Internal Growth: ‡ Generated through increasing sales ‡ To increase sales firms need to:
± Market effectively ± Invest in new equipment and capital ± Invest in labour

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The Growth of Firms
External Growth: ‡ Through amalgamation, merger or takeover (acquisitions) ‡ Mergers ± agreed amalgamation between two firms ‡ Takeover ± One firm seeking control over another
± Could be µfriendly¶ or µhostile¶
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External Growth
‡ Vertical Integration ‡ Horizontal Integration ‡ Conglomerate Merger

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The Growth of Firms
External growth ± types of acquisition: ‡ Vertical integration ± amalgamation, merger or takeover at different stages of the productive process

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Vertical Integration
Primary Vertical Integration Backwards ± acquisition takes place towards the source

Secondary

Manufacturer

Tertiary

Retail Stores

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Vertical Integration
Primary Dairy Farming Cooperative Vertical Integration Forwards ± acquisition takes place towards the market

Secondary

Cheese Processing Plant

Tertiary

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Horizontal Integration
‡ Amalgamation, merger or takeover at the same stage of the productive process

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Horizontal Integration
Primary

Confectionery Secondary Manufacturer

Soft Drinks Manufacturer

Tertiary

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Conglomerate Acquisition
‡ Amalgamation, merger or takeover of firms in different lines of business.

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Motives
‡ Cost Savings
± External growth may be cheaper than internal growth ± acquiring an underperforming or young firm may represent a cost effective method of growth

‡ Shareholder Value
± Improve the value of the overall business for shareholders

‡ Asset Stripping
± Selling off valuable parts of the business

‡ Economies of Scale
± The advantages of large scale production that lead to lower unit costs

‡ Managerial Rewards
± External growth may satisfy managerial objectives ± power, influence, status

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Motives
‡ Efficiency
± Improve technical, productive or allocative efficiency

‡ Control of Markets
± Gain some form of monopoly power ± Control supply ± Secure outlets

‡ Synergy
± The whole is more efficient than the sum of the parts (2 + 2 = 5!)

‡ Risk Bearing
± Diversification to spread risks

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Key Issues

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Key Issues
‡ Divorce between ownership and control ± who runs the business?
± Shareholders? ± Board of Directors?

‡ Principal-Agent Relationship:
± Shareholders act as principals, Board as agents ± principals expect agents to act in their interest ± Sub-contracting work operates on a similar basis ± Contracts and compensation procedures to ensure agents act on behalf of principals

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Key Issues
‡ The Law of Diminishing Returns: ± Increasing successive units of a variable factor to a fixed factor will increase output but eventually the addition to output will start to slow down and would eventually become negative ‡ To prevent diminishing returns setting in, all factors need to be increased ± returns to scale
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Key Issues
Diminishing Returns ± assume the amount of land/plant was fixed. Adding labour and capital units would initially increase output but the rate at which output would rise will start to decline and eventually would become negative unless the amount of land/plant was increased to accommodate the increase in variable factors.

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Diminishing Returns ± Graphical representation
Output

Total Product (TP)

Quantity of the variable factor
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Efficiency

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Productive
‡ Lowest Cost ± Productive efficiency can be achieved where the same output could be produced at lower total cost ± Achieved through re-organisation (e.g. to cell production), investment in new technology, training for staff and so on
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Technical
‡ Minimum inputs
± Technical efficiency can be achieved if the same output can be produced using fewer inputs ± Can be achieved using labour saving devices, more efficient machinery, more effective re-organisation of restructuring and so on

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Allocative
‡ Needs of Consumers (P = MC) ‡ Allocative efficiency occurs where the goods and services being produced match the demand by consumers ‡ P = MC ± the value placed on the product by the buyer (the price) = the cost of the resources used to generate the good/service

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Social
‡ MSC = MSB ‡ Social efficiency occurs where the private and social cost of production is equal to the private and social benefits derived from their consumption ‡ A measure of social welfare

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Motives of Firms

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Profit Maximisation
‡ Profit maximisation ± assumed to be the standard motive of firms in the private sector ‡ Profit maximisation occurs where Marginal Cost = Marginal Revenue ‡ MC = MR ‡ The firm will continue to increase output up to the point where the cost of producing one extra unit of output = the revenue received from selling that last unit of output ‡ This assumes that firms seek to operate at maximum efficiency
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Profit Maximisation ± Diagrammatic Representation
Cost/Revenue
150 145 140
Total added to profit 120

Added to total Added profit to total profit 40 30 20 18

Reduces total profit by this amount

Assume output is at MC If100 process addition the firmdecides If The firm the continues the units. The totoof MC ± were th MR ± The MC cost produce thethe 100 forto total more unit each successive producing 104 unit, produce one revenuethas± ofproduced. cost this101producing unit result would last unit unit the a isst20. of addition ± the ONE the one 18, more to produce unit toProvidedextra than it total cost is nowis producing MC from The in received earns MRrevenue (-105) less than to total more unit MR unit of production the additionthe of th it selling that this output reduce total willwould ± 100 price be worth the can revenue is 140 ± the firm is 150. Theoutput as firm profit and so from notit expanding to profit ± received will add 128 would of add difference the be worth difference sellingand the that extra is the cost producing. worth expanding the between the two is output. The unit. received from profit revenue maximising ADDED to total profit. output is where MR = that 100th unit to MC. profit (130). MR 104 Output

100

101

102 103

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Revenue Maximisation
‡ ‡ ‡ ‡ Total Revenue Average Revenue Marginal Revenue In this model the policies to achieve revenue maximisation may be different to those adopted to maximise profits

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Other Objectives of Firms
‡ Sales maximisation:
± Attempts to maximise the volume of sales rather than the revenue gained from them

‡ Share Price Maximisation:
± Pursuing policies aimed at increasing the share price

‡ Profit Satisficing:
± Generating sufficient profits to satisfy shareholders but maximising the rewards to the managers/board and avoiding attention from rivals or regulatory authorities
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Behavioural Objectives
‡ Modern firms have to attempt to match competing stakeholder needs:
± Shareholders ± Employees ± Consumers ± Suppliers ± Government ± Local communities ± Environment
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Behavioural Objectives
‡ Firms may have to balance out their responsibilities:
± µFat cat pay¶ ± Management rewards ± bonuses, etc. ± Social and environmental audits ± Employee welfare ± Meeting consumer needs ± Paying suppliers on time ± Satisfying shareholders and µThe City¶ about its policies, plans and actions
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