Unit 6 - Business behaviour

Economies/diseconomies of scale

Economies of scale are the advantages, in the form of lower long-run average costs, of producing on a larger scale. These benefits may derive from the growth of a firm itself or from the growth of the industry in which it operates. This is why economists distinguish between internal and external economies of scale. Be sure that you understand that economies and diseconomies of scale happen only in the long run, when all factors of production are variable.

Classify the following costs of a textile manufacturer into fixed and variable costs before checking your answers below. 1. Rent of a factory 2. Pensions to ex-employees 3. Raw material costs 4. Repayment of loans 5. Delivery costs 6. Fuel bills

1. fixed 2. fixed 3. variable 4. fixed 5. variable 6. variable

Sales maximisation

A firm which has the objective of sales maximisation aims to sell as many of its products as possible. It may do this in several ways: - by reducing the prices of its goods and services in order to attract more customers and bigger orders - by expanding its product range in order to gain customers and sales from different market segments, for example a manufacturer of fashion clothing for young people may expand into the market for children's clothing - by spending more on advertising and marketing. Some large firms may see sales as a more important objective than profits; in such a case sales maximisation, rather than profit maximisation, might be the main objective of a firm. Sales are seen as an important indicator of size and so a firm needs to sell more if it is to achieve the safety and prestige of being big - and, ultimately it hopes, the long-term profit as well. We shall be studying the size of firms in Topic 2 but it is worth noting here that a firm which achieves higher sales: - more than likely has a larger market share, i.e. its sales are a large proportion of the total sales in the market for the product, giving it more power within its market - is able to diversify into many different markets and market segments - is more able to survive in difficult economic conditions. In many large firms, there is a divorce between ownership and control. The shareholders own the company but the top executives take the decisions. The shareholder group does not play an active part in deciding on objectives and the top executives' decisions may be based on objectives which enhance their own position. They may be more interested in maximising sales than profits for a number of reasons: - The salaries and bonuses of managers are often more closely linked to sales than to profit; an executive who is achieving a rising quantity of sales may expect to be rewarded with an attractive pay package or bonus. - High and expanding sales often makes it easier for a firm to raise external finance through borrowing and issuing shares. However, to say that a firm's objective is to maximise its sales does not imply that the firm is not interested in profit at all. All privately owned firms must make profits for the reasons outlined in the previous section; indeed, they cannot continue to operate at a loss. A sales-maximising firm must always aim for at least a minimum profit and its attempts to increase its sales are always subject to this constraint. But this does not necessarily mean that they will always aim to make a maximum profit. Firms that opt for sales maximisation do not simply aim to produce as much as possible. What they actually aim for is the maximum level of output that can be produced while making a profit that will satisfy the shareholders. Note in what follows that maximising sales is not the same as maximising profits. In order to achieve a maximum level of sales, a firm has to reduce its selling price, thus narrowing its profit margin; it also has to increase its marketing expenditure, thus increasing its costs. Figure 1.3 below shows a firm which is maximising its sales. Profit is maximised at Qπ and revenue is maximised at Qr, as before. But sales are maximised at Qs, which is the point at which total revenue TR equals total cost TC. This is because a firm which wants to maximise its sales will continue producing and selling as long as it is making profit but it will not go beyond the point at which it starts to make a loss. Thus it produces or sells up to the point where it just breaks even. In order to sell more, the firm has to reduce its price on all units sold. It would be possible for a firm to reduce its price to such a low level that it makes a higher level of sales than before but with a lower revenue. Study hint: It is very important that you are able to distinguish between sales and profits and to use the terms correctly in your writing. A lot of students talk about profits when they mean sales. For example, they might say that a firm can improve its product so it can make more profit. What they mean is that a better product should achieve higher sales - but whether profit is higher or not depends on what happens to costs. It would be possible for a firm to spend so much on product development that it achieves higher sales but makes a lower profit.

Profit maximisation

Making a profit is a main objective of nearly all businesses. Put simply, profit is the difference between what a firm receives from its sales and what it costs it to make its products. More formally, profit is the difference between the amount of money (revenue) received by a firm from the sale of its products (total revenue or TR) and the amount of money spent by the firm on its costs of production and administration costs (total cost or TC). The aim of profit maximisation, as the name suggests, is for a firm to make as much profit as possible. Profit maximisation is likely to be a firm's main objective where the shareholder group is powerful and puts pressure on management to pay as much dividend as possible. (See the notes on divorce between ownership and control in the section on sales maximisation below.) In simple terms, profit is the difference between revenue and cost, and maximum profit means the greatest difference between total revenue and total cost. This is illustrated in Figure 1.1. TC is Total Cost. This is cost per unit multiplied by the number of units produced, so this increases as the number of units produced increases. (Note that total cost can be broken down into subdivisions; we will study this in Topic 4.) TR is Total Revenue. This is price per unit multiplied by the number of units sold and it increases at first as demand rises. But it eventually falls because the firm has to lower the price in order to sell more. TR reaches a peak and then falls, as the number of units sold fails to compensate for the decrease in price. We will look at this in more detail in Topic 3, specifically in Figures 3.3 and 3.4. The learning point here is that the firm maximises profits at the point of output where the difference between TR and TC is at its greatest, i.e. at output Qπ. (Note that the Greek letter π or 'pi' stands for profit.) Economists have traditionally seen profit maximisation as the main objective pursued by firms. Profit is important as it performs several functions: - It rewards owners (shareholders in the case of a company) with a dividend (share of the profits) in return for bearing the risks of being in business. - It enables the firm to save money in a reserve from which it can draw in the event of an economic downturn. - It can be used to finance investment in, for example, new equipment, product development or entering new markets. - It is an indicator of success and gives a signal to the financial markets that the firm is doing well and makes it easier for a growing firm to find new investors. As we shall see in Topics 3 and 4, economic theory allows us to use revenue and cost figures to determine the point of output at which a firm will make a maximum profit. This is a marginal decision whereby a firm makes decisions on whether or not to continue to produce more units of output on the basis of whether these additional (marginal) units add to or subtract from total profit. Study hint: The concept of the 'margin' is a very important one to grasp at the outset. A marginal unit means 'one more unit' or 'the next unit'. For example if a factory produces 1000 washing machines a day and then decides to increase its daily production to 1001, the 1001st washing machine is the marginal unit produced. If a unit is very small, the marginal unit might refer to a batch of individual units, e.g. a batch of 100 loaves of bread. A practical application of this would be a firm which is considering whether or not to accept a new additional contract and which makes its decision on the basis of whether the new order would result in a higher or a lower total profit than before.

Constraints on business growth Regulation

Many countries, the UK included, have competition laws which aim to protect customers by limiting the amount of market power that a large firm can secure. This can be done by investigating proposed mergers and acquisitions and recommending that they should be prohibited if the resulting large company is likely to act against the public interest. In 2012, the cinema chain Cineworld bought Picturehouse, another cinema chain serving a different market segment. Three areas of the UK (Aberdeen, Bury St Edmunds and Cambridge) had one of each cinema, resulting in limited competition and the threat of higher prices to cinema goers in those areas. The takeover was referred to the Competition and Markets Authority (CMA). In 2013, the CMA required Cineworld to divest (sell off) one of the cinemas it owned in each of these areas to an operator approved by the CMA in order to preserve competition to the consumer. The Competition and Markets Authority in the UK is an independent non-ministerial department which works 'to promote competition for the benefit of consumers'. One of its responsibilities is 'to investigate mergers which could restrict competition' (CMA, 2016).

Profit maximisation Topic 5

Maximum profit for a firm means the most a firm can make. It could be at the point of normal profit, but it could also be much more and could contain a large amount of abnormal or supernormal profit. We can distinguish between short-run and long-run profit maximisation. - A firm which practises short-run profit maximisation decides on the product price and level of output which will give it the best financial return now, taking into account the conditions currently prevailing in the market. During an economic boom, a firm may expect to make a high profit; during a slump, it may have to realise that the best it can do is to minimise its losses. Note that survival is an objective in unfavourable economic conditions. Economic theory would tell us (see Topic 4) that a firm which makes a loss will leave the market. But a firm may be prepared to stay in the industry as long as it can pay its suppliers and workers and make some contribution to its other costs, including rent, if it believes it can 'weather the storm' and make a profit in the long run. - In the long run a firm must make a certain minimum profit in order to stay in business, unless it can be subsidised by another firm in the same group or by the government. (See the example of Lloyds Banking Group and the Royal Bank of Scotland in Topic 2.) However, it may not aim to maximise profit, as we shall see below. If a firm aims to make a maximum profit, it must know at what point of output it will do this. In Topics 3 and 4 we drew revenue and cost curves in which the horizontal axis of the graph plotted the firm's output, measured in numbers of units, and so a firm which wants to maximise its profits needs to know at what point along the output axis it should stop producing. In other words, what is its profit maximising output? To calculate the profit graphically, we will need to bring together the revenue and cost curves. Instead of using total revenue and total cost curves, we can use average revenue and average cost curves and then multiply by the output to find the total profit. But the average revenue and average cost curves will not tell us where profit is maximised. Imagine that a firm is growing and moving along the horizontal output axis. If by growing even more it can make more profit, it will do so; but when it reaches the point where more output will be loss-making and will therefore reduce total profit, the firm will not expand its output any further. The firm is making marginal decisions as to whether or not to make another unit (or perhaps, more realistically, another batch of units), based on whether this unit will add to its profit or not. So, to discover the point of maximum profit, we need to use the marginal revenue and marginal cost curves. Economic theory has formed the following hypothesis: A firm will maximise profits at that point of output where marginal revenue (MR) equals marginal cost (MC). MR = MC This means that the amount received from selling the last additional or marginal unit is just equal to the cost of producing that additional unit. Study hint: Note that if a firm is producing output at the point where MR = MC, this does not mean that it is breaking even as a whole. It simply means that it is breaking even on the last unit produced but the previous units it has produced have been profitable. We can explain this by looking at three graphs. We will use a downward sloping marginal revenue curve (as in Figure 3.3 in Topic 3) and a U-shaped marginal cost curve (as in Figure 4.1 in Topic 4). In Figure 5.1 below, the firm is producing at o1. At this output, marginal revenue is higher than marginal cost, so the marginal unit is profitable. But if the firm stops producing at this point, it is missing out on all the additional profit XYZ it could make by expanding up to the point where MR = MC. XYZ is made up of many individual lines which represent the profit on all the additional units between o1 and oe. So the firm is not in equilibrium in this graph and it will continue to expand its output. In Figure 5.2 below, the firm is producing at o2. At this output, marginal cost is higher than marginal revenue, so the marginal unit is not profitable. The firm is producing too much and is making a loss of ZAB. ZAB is made up of many individual lines which represent the loss on all the additional units between oe and o2. So the firm is not in equilibrium in this graph and it will reduce its output. In Figure 5.3, the firm is producing at oe. At this output, marginal revenue is just equal to marginal cost on the last unit produced. The firm is achieving all the profit between MR and MC to the left of oe but is avoiding the losses which exist between MC and MR to the right of oe. This firm is in equilibrium and has no incentive to produce more or less units. Now look at the figures in Table 5.1 and see if you can understand how all the figures have been derived. In this example, the most profitable output is 4 units since this is where MC = MR. The gap between total revenue and total cost at this point is £15. There is no point at which this gap is greater.

The law of diminishing returns

Productivity means the amount of output produced by one factor of production (one worker or one machine) within a stated period of time. In other words, it is output divided by input. The law of diminishing returns (also known as diminishing marginal productivity) is a very fundamental economic law or tendency and it applies in the short run only. It says that, as a firm adds increasing numbers of a variable factor to a fixed factor, the additional (marginal) output from each successive variable factor rises to begin with (increasing marginal productivity), but reaches a peak and then begins to fall, giving diminishing marginal productivity. You can understand this from a common-sense point of view if you think about the following example. A firm provides care for older people in their own homes. One of the firm's jobs is to provide a morning visit to an old lady, give her a shower, make her bed and prepare her breakfast. If one carer does all these jobs, it will take 30 minutes. But if there are two carers, the jobs can be shared and the visit will take 20 minutes. It might be possible to reduce the time still further if a third carer is added but, after this point and with the addition of a fourth, a fifth and even a sixth carer, there will be inefficiency and things may even become chaotic. The carers will get in each other's way, there won't be room in the bathroom, jobs might be duplicated and one carer might even undo what another carer has done. This example illustrates initial increasing returns and eventual diminishing returns to the variable factor (carers). We can see the results of diminishing returns in the behaviour of the average variable cost curve. As output increases, average variable cost falls at first as the combination of factors of production employed becomes more efficient. However, beyond a certain output, diminishing returns set in when the combination of resources becomes less efficient. If additional units of a variable factor of production are being bought at the same price and are adding increasingly less to output, because the most efficient combination of resources has been passed, average variable cost will rise. This explains the behaviour of the costs in Table 4.7 which you have already studied. Go back and look at it again with diminishing marginal returns in mind. The theory of diminishing marginal returns was developed in the late eighteenth and early nineteenth centuries by economists such as David Ricardo. He showed that increasing units of a variable factor, when applied to a fixed factor, eventually have decreasing returns. He used the example of increasing numbers of labourers being employed to work a piece of land. Figure 4.2 shows the average variable cost (AVC), average total cost (AC), marginal cost (MC) and average fixed cost (AFC) curves of a product. The first three rise after a certain point because of diminishing returns. In the short run a firm is faced with both fixed and variable costs. If the firm believes that demand will increase or that costs can be cut, it will continue to produce in the short run even if it is making an overall loss, as long as it is covering at least the variable costs. This is because it can see the payment of some fixed costs as sunk costs, i.e. costs which have already been paid for. For example, once a machine has been purchased, there is no further opportunity cost. Additionally, if a firm continues trading, as long as its sales revenue is more than its total variable costs, it is making a contribution to the fixed costs, whereas if it closes down it can make no contribution. However, in the long run, it must cover all costs.

Profit

Profit is the return earned by the factor of production called enterprise. In numerical terms it is the difference between the revenue a firm earns and the costs it incurs.

Fixed cost and variable cost

The discussion of total cost did not make any distinction between types of cost or whether we are discussing the short run or the long run. These distinctions are covered in this section. Total cost can be subdivided into fixed costs and variable costs. Total cost = fixed cost + variable cost or Total cost - variable cost = fixed cost or Total cost - fixed cost = variable cost - Fixed costs (FC): Fixed costs are those costs which do not change when output changes. When additional units are produced, fixed costs remain the same. They are overheads and indirect costs which are not associated directly with making the product. Take the example of a firm making flowerpots. The rent of the factory is the same however many flowerpots are produced, and so there is no direct relationship between the rent and the number of units of output. Fixed costs are expressed in totals. They can be calculated in various ways and are often the result of agreements, e.g. a manager's salary or the rent of a building. Note that when a firm is producing no units at all, it must still pay its fixed costs (unless it closes down completely). So if it shuts for the summer holiday, or closes temporarily during a period of recession, it must still pay its managers' salaries and its rent and business rates. If you see that a firm is paying a certain amount of cost but is producing no units, you can assume that all of these are fixed costs. - Variable costs (VC): Variable costs are those costs which change when output changes. They are direct costs such as the cost of raw materials and the cost of productive labour, i.e. workers who are paid by the hour or by the number of units produced. In order to make more flowerpots, the firm must purchase more clay and hire labour for more hours. Variable costs are expressed per unit, e.g. raw materials per units produced, wages per item sold. Note that if employees are being paid an annual salary, this form of labour is a fixed cost as the remuneration is not linked to levels of output. Also note that variable costs are incurred only if production takes place. No variable costs have to be paid if no units are being produced. Study hint: A common mistake made by students is to define fixed cost as a cost which is not increasing because prices have not changed. Equally, variable costs are defined as those which are rising with the rate of inflation. This is incorrect. Both fixed and variable costs are defined in relation to the number of units of output being made by a firm. Variable costs are those costs which rise or fall depending on the number of units. Fixed costs are those costs which, in the short run, remain the same however many units of output are made. In Topic 1 we discussed the difference between the short run and the long run. We defined the short run as 'that period of time during which the scale of a firm's operation is fixed' and we said that 'a firm has flexibility only in decisions affecting variable factors'. We also said that in the long run, 'all factors of production are variable'. Remember that factors of production are the resources which are brought together to make production possible, and that they are land, labour, capital and enterprise. Thus, in the short run, a firm has at least one fixed factor of production. In the above example of the flowerpots, the fixed factor is the factory which costs rent, but it could be a manager who is paid a salary or the cost of a new computer. The variable factors of raw materials and labour are used together with the fixed factors and total cost is divided into variable costs and fixed costs. In the long run, however, all factors of production are fixed up to the point of full capacity. If the flowerpot firm is not using all its factory space, it has spare capacity and it can produce more units without paying more factory rent. However, if it expands it will eventually arrive at the point where the factory is being used to full capacity and there will be no room to produce more flowerpots. At this point, and assuming that the firm wants to continue to grow, it must rent a new factory building and pay a higher rent; the fixed cost has become variable at this point. Study hint: Table 4.4 shows a firm's short-run costs and how these are divided into fixed and variable costs. Note that there is a cost of producing zero units, and this is the fixed cost of £90, which remains the same throughout the table. Also note that the variable cost column gives the total variable cost and not the variable cost per unit.

Conglomerate integration

Conglomerate integration happens when a firm grows by merging with or taking over a firm or firms which are producing different types of products or operating in different sectors. Some large conglomerates have a very wide range of products indeed and have built up their product portfolio by buying up different companies from time to time. See the example of Unilever in Activity 2. This sort of growth enables a firm to raises its output, sales and probably its profits by producing a greater range of products. It also benefits from wide diversification, spreading its risks over different products and sectors. A company that makes a variety of products may be able to cover a temporary loss suffered in the market for one of its products by making profits on its other products; and, if necessary, it can shift resources between products.

Profit and not-for-profit organisations

A wide range of organisations exists in an advanced economy. Some of these organisations aim to make profits, but others have different purposes. As you have already seen, businesses which operate to make a profit are commercial enterprises - mainly sole traders, partnerships and limited companies - and they exist almost exclusively in the private sector. Organisations which do not aim to make profits are known as 'not-for-profit' organisations and they exist in both the private and the public sectors. As you saw above, public sector organisations (e.g. the NHS) exist to provide a service or to carry out a duty with which they have been entrusted. But not-for-profit organisations can also be found in the private sector, e.g. charities. Here are two examples of charities. - Save the Children is an international charity. Here is how it describes its mission: 'Save the Children works in 120 countries. We save children's lives. We fight for their rights. We help them fulfil their potential' (STC, 2016). - StepChange is a charity which provides free debt advice to people who owe money: 'Our vision: we want to create a society free from problem debt' (StepChange, 2016).

Revenue maximisation

A firm which has the objective of revenue maximisation aims to receive as much money from selling its products as possible. To earn more revenue, a firm can adopt one of two policies: - It can sell more units of its product by reducing price and stimulating demand. However, if the price is reduced by too much, the firm might actually earn less revenue; although it will almost certainly make more sales, each unit sold is bringing in only a small amount of revenue. - It can sell the same number of units at a higher price. However, this will be possible only if there is an increase in demand (i.e. a shift to the right of the demand curve) for some reason, perhaps a rise in consumers' income or a rise in the price of a competitor product. In practice, a firm will do some combination of the above. It will decrease its price to sell more, but not beyond the point at which revenue begins to fall. To know where this point is, a firm needs to know the price elasticity of demand for its product. It can continue to drop its price as long as demand is relatively elastic, i.e. the proportionate increase in the quantity sold is greater than the proportionate fall in price. At the point where demand is relatively inelastic, a firm cannot increase its revenue by decreasing the price of the product. Figure 1.2 shows the point where a firm maximises its revenue. Note that it is a similar graph to Figure 1.1, which depicts profit maximisation, but it also includes revenue maximisation. - As you have already seen, the firm maximises profit at the point where the difference between TR and TC is widest, i.e. at quantity Qπ. - The firm maximises revenue at the point where revenue is greatest, i.e. at the top of the U-shaped revenue curve, at quantity Qr. This is not the same point of output as the profit maximisation output. Note that a firm which is maximising its revenue is producing and selling a greater quantity than a firm which is maximising its profits; it has reduced its price in order to sell more.

Private and public sector organisations

All of the firms we have discussed so far operate in the private sector. They are owned by private individuals, or groups of individuals, and their aim is to make a profit for these owners. Whether a firm is a small corner shop or a huge multinational company, it operates for private interests. But some organisations are owned by the public sector - either by the central government, by a local authority or by a public corporation which has been set up by the government. Two examples are the Bank of England - the central bank of the UK, which is a corporation wholly owned by the UK government - and public sector hospitals which are run by local health trusts or health boards. The prime objective of public sector organisations is usually not the generation of profit for distribution but the provision of benefits, either to the country as a whole or to deliver a service to their users. They provide public goods and merit goods (see Section 3 Topic 1). Public sector organisations are funded by the government and so they do not rely on selling products in order to gain revenue to cover their costs, although they are expected to remain within their budgets. The mission of the Bank of England is to 'promote the good of the people of the United Kingdom by maintaining monetary and financial stability' (Bank of England, 2016). The purpose of the Abertawe Bro Morgannwg University Health Board in South Wales (NHS Wales, 2016) is to 'fulfil our civic responsibilities by improving the health of our communities, reducing health inequalities and delivering effective and efficient healthcare in which patients and users feel cared for, safe and confident'. In the UK in recent years, there has been some blurring of the lines between the private and public sectors, as a lot of public sector services are now outsourced to private companies. For example, some prisons are run by private security firms. Study hint: Note carefully the difference between a public limited company and a public corporation. A public limited company is a privately owned enterprise. It is owned by its shareholders and aims to make a profit for them. Although it operates in the private sector, it is called a 'public' limited company because its shares are available for sale to the general public. A public corporation is an organisation owned and financed by the public sector in order to fulfil a stated mission for the country as a whole rather than making a profit.

Behavioural theories and profit satisficing

Behavioural theories suggest that firms are made up of a range of different stakeholder groups and are therefore likely to have a number of objectives. The objectives followed at any one time will depend on the strength of the respective stakeholder groups and on the extent to which the differing objectives can be reconciled. A stakeholder approach can result in profit satisficing. This means that a firm aims not for maximum profits but for a level of profit which is considered to be 'satisfactory'. In practice this means a profit which enables the firm to pay enough dividend to keep existing shareholders happy and to attract new shareholders, but which is not so large as to prevent other stakeholder groups from achieving their objectives. Here are a couple of examples: - Aiming for satisfactory rather than maximum profit may enable managers to grow the business into new markets and products. This may be costly and profits may fall, but executives will achieve more job satisfaction and probably a higher financial reward. And, taking a more long-term approach, such a strategy might make the firm's future more secure. - Environmental groups may put pressure on a gas firm to site a pipeline underground rather than run it above ground through an area of outstanding natural beauty. Burying the pipeline will be costly and will probably reduce profit but it will enhance the firm's reputation within society as a whole. Satisficing may sound like a good compromise between stakeholder groups with opposing interests but, in practice, the most powerful group is likely to have the greatest influence on policy.

Summary of Profit

Normal profit is included in costs of production and is the minimum which has to be earned to keep the firm in the industry in the long run. Supernormal profit is profit in excess of normal profit. It provides an incentive for firms outside the industry to try to enter. Such entry may be prevented by the existence of barriers to entry and exit. Profit is maximised at that point of output where marginal revenue is equal to marginal cost.

Normal profit

Normal profit is a concept and is not something we can give a formula for, as each entrepreneur has his or her own idea of what it should be. Normal profit is the minimum profit which a firm must make in order for the owner or owners to continue in production and for the firm to continue in the industry in the long run. It must be at least the amount which the owner could earn in his or her next best alternative employment. Take the example of a man who gives up his job where he earns £20,000 a year in order to open his own shop. We would say that his normal profit is £20,000; if the shop gives him less profit than this, he would be better off closing the shop and going back to his previous job. Clearly there are certain practical problems involved in this but the principle is one of opportunity cost. If the shop owner has given up £20,000 to be self-employed, he needs to make at least this amount in profit for him to cover the cost of giving up his job. Some entrepreneurs might feel that they need to earn more in profit to cover the uncertain risks and to compensate them for the long hours spent in organising the factors of production they employ. Working for yourself involves risks, effort and stress. Since normal profit is the minimum return entrepreneurs must earn in order to keep producing the product, it is as if the owner is paying himself a salary. For this reason, it is seen as a cost of production for the firm. A firm makes normal profit at the point where total revenue is just equal to total cost. (This may sound as if it is just breaking even, but we must remember that normal profit is a cost of production.) Arithmetically, if total revenue equals total cost, average revenue (AR) must equal average cost (AC) and this is the condition for making normal profit. AR = AC If average cost exceeds average revenue, the firm is making a loss. On the other hand, if average revenue exceeds average cost, the firm is making supernormal profit (which we will investigate on the next page).

Supernormal profit

Supernormal profit, which is sometimes also called abnormal profit or excess profit, is profit in excess of normal profit. It means that the owner of the firm is receiving a return which is greater than the amount needed to keep the firm in business. Supernormal profit may not last beyond the short run because it will act as an encouragement to new firms to enter the market to try to compete away the excess profit being made. However, if there are barriers to entry into and exit from the market (see Unit 7), incumbent firms may be able to enjoy supernormal profits in the long run. In markets where competition is limited and where individual firms have monopoly power, these firms can earn supernormal profit into the long run. They do this by erecting barriers to entry to make it harder for new competitors to enter the market. There are also other ways in which they can apply their power and you will be looking at these this in Unit 7.

Topic 5 - Proft

This topic explores the concept of profit in more depth and explains how a firm can maximise its profits.

Which is an example of an external economy of scale? a) A firm employing specialist management staff b) A firm exporting a proportion of its output c) A firm receiving a discount on its purchase of raw materials d) A firm reducing its unit transport costs by using larger goods vehicle e) A firm sending some of its staff on courses at a local college

The answer is (e). An external economy of scale is a benefit a firm can gain as a result of the growth of the industry within which it operates. If an industry grows sufficiently large, a local college may put on specialist courses to cater for the industry. (a), (c) and (d) are examples of internal economies of scale. (b) is not related to a cost saving.

Disadvantages of integration

The advantages of the different types of integration were set out above. But growing in this way can also have disadvantages and harmful effects on various stakeholder groups. One of the first effects of a merger or a takeover is rationalisation. This means that, because there is now duplication in the new company, some factories, shops or offices may be closed and some workers will be made redundant. This can demoralise the existing staff and make the new company unpopular with the public. A merger or takeover may also be against the interests of consumers as it reduces the number of competitors in the market and limits consumer choice. The number of retail banks in the UK has fallen over the last couple of decades and there is a high concentration in the market for certain products: more than 75% of personal current accounts are sold by the four biggest banks. For this reason, the government and the financial regulator are trying to encourage new banks to come into the market; these are known as 'challenger' banks. Carrying through a merger or a takeover is also a very expensive business in terms of time and cost. Companies are not able to carry out this integration on their own; they need to hire the services of investment banks - and the bills can be very large. In any case, external growth does not guarantee that the most efficient size will be achieved. The new company which results from the integration may be too large and may suffer from diseconomies of scale. There can also be a disadvantage in backwards vertical integration in that, if a firm commits itself to obtaining its supplies from the firm it has acquired, it is unable to benefit from the possibility that competing independent suppliers might offer the same supplies at lower prices. In March 2016, the supermarket chain Sainsbury's made a bid to purchase Home Retail Group, the company which owns Argos, the home and general merchandise retailer. David Tyler, Sainsbury's chairman, said: 'The UK grocery retail industry is undergoing a period of intense change in customer shopping behaviour and in the competitive environment. ... This combination with HRG will allow us to create a multi-product, multi-channel proposition with fast delivery networks that we believe will be very attractive to the customers of both businesses.'

Vertical integration means the merger between firms: a) at different stages of the productive process b) making different types of product c) making different products in different countries d) making the same type of product and at the same stage of production e) making the same type of product in the same geographical area

The correct answer is (a). Vertical integration occurs when two firms at different stages of the productive process making the same product merge (for example, a clothes shop chain merging with a clothing manufacturer). Answer (b) is a conglomerate merger and (d) a horizontal merger.

Which type of profit is included in costs of production? a) Abnormal profit b) Excess profit c) Normal profit d) Supernormal profit e) Surplus profit

The correct answer is (c). Costs of production cover all the payments that are made to produce a product. Normal profit is the minimum profit that has to be paid to an entrepreneur to keep the firm in the industry in the long run. Abnormal profit, excess profit, supernormal profit and surplus profit are different names for profit above the normal profit level. Such a surplus is not included in costs of production and is the difference between revenue and costs.

Fixed costs are: a) Costs that do not alter with inflation b) Costs that do not change in the long run c) Total costs less variable costs d) Total costs less marginal cost e) Total cost divided by output

The correct answer is (c). Fixed costs plus variable costs are equal to total costs, so total costs less variable costs give fixed costs. (a) is incorrect as all costs can vary with inflation. (b) can be rejected as, in the long run, all costs will be variable costs. (d) does not give anything. (e) defines average cost.

A firm's managers aim to pay out sufficient dividends to keep its shareholders happy whilst seeking to restructure the firm and to raise their own salaries. What objective are they pursuing in the short term? a) Profit maximisation b) Profit minimisation c) Profit reduction d) Profit satisficing e) Profit sharing

The correct answer is (d). The firm's managers are seeking to keep shareholders content with the share of profit distributed to them while increasing their own rewards and restructuring the firm. Such an approach is described as profit satisficing. Answer (a) would involve making as high a level of profit as possible. Managers would be unlikely to try to minimise or reduce profits (b) or (c). (e) would mean a scheme whereby managers and/or workers are given shares in the firm to increase their motivation.

The principal-agent problem

The owner of a sole trader firm performs a dual function. He or she is the owner of the business who takes the risks and receives all the profits. At the same time, he or she is the manager who takes all the decisions. These decisions may be influenced by the amount of profit that the owner wants to make, but there is no conflict of interest. The same applies to partnerships with a few members and to private limited companies with a few shareholders. But this is not the case in a public limited company. The company is owned by its shareholders (the principals), who could be other companies or private individuals, but it is run by paid executives (the agents) who may or may not hold shares in the company. Most of the shareholders will take no part in management decisions but delegate them to the executives. This is the divorce between ownership and control mentioned in Topic 1. The aims of the two stakeholder groups may not coincide: the managers may push for higher sales in order to earn higher bonuses, but this may result in lower profits, which means that the shareholders receive lower dividends.

The short run and the long run

The rest of this topic looks in some detail at the main objectives which a firm might be working to achieve. One very important distinction which will be made is that between the 'short run' and the 'long run'. This distinction will also arise in other topics throughout this A Level Economics course. Clearly the distinction between the short and long run is one of time, but we do not specify the actual period of time involved; rather, we distinguish between a shorter period of time and a longer period of time. The main distinction in economics concerns that period of time over which a firm does or does not have flexibility in making production decisions. The short run is defined as that period of time during which the scale of a firm's operation is fixed. The scale could be measured by the amount of factory, office or shop space that the firm has access to. The firm cannot alter the scale in the short run, as it takes time to buy or rent new premises. But in the short run, the firm can alter its variable factors; these are mainly the number of production workers employed and the amount of raw materials purchased. So it has flexibility only in decisions affecting variable factors. Take the example of a call centre which has spare space. If business grows, the call centre can hire more employees quickly and can expand into the spare space. Or, if business falls off, the firm can hire fewer workers. The only decision the firm can make is the number of employees to hire; the premises are fixed. However, over a longer period of time - the long run - the firm is able to find and rent or buy bigger premises or open a new branch. (Indeed, when the call centre is working at full capacity and there is no room for more desks and more people, the only way the firm can expand is by acquiring more space.) The firm now has flexibility not only in the number of workers to hire but also in the scale of its operations. In other words, all the factors of production are flexible, or variable.

Topic 1 - Business objectives

This first topic in Unit 6 will introduce you to some of the business objectives a firm may choose to pursue. In particular, you will consider the objectives of profit maximisation, revenue maximisation, sales maximisation and satisficing.

Summary of Firms and growth

This topic has examined why and how firms grow. It has also explored the implications of growth. The key points are as follows: - Growth may enable a firm to increase its market share and gain higher profits. - There are a number of factors that can limit growth, including reaching the most efficient size and lacking the capital to grow further. - Firms can grow internally by reinvesting profits, or externally by mergers or takeovers. - A vertical merger involves firms at different stages of production; a horizontal merger is one between two firms at the same stage of production; and a conglomerate merger is between two firms making different products. - Vertical mergers can increase control over the quality of raw materials or outlets; horizontal mergers can increase economies of scale and reduce competition; conglomerate mergers can result in risks being spread more widely. - A firm may decide to split itself into two or more separate firms so that it can specialise more, avoid diseconomies of scale and raise its share price.

Summary of Business objectives

This topic has focused on the key objectives which motivate firms. The key points are as follows: - An industry consists of firms producing the same product. - A firm's objectives may be influenced by a range of stakeholders including owners, managers, workers, consumers, suppliers, environmental groups and the government. - A firm seeking to maximise profit in the short run will alter price and output if market conditions change. - Where there is a divorce of ownership between shareholders and managers, firms may seek to maximise revenue or sales. - Achieving a level of profits which satisfies shareholders may enable a firm to pursue other objectives.

The following are all mergers that have occurred in recent years. Work out whether each one was a conglomerate, horizontal or vertical merger and write your answer in the right-hand column. Date, Merger / takeover 1. 2015, BT (telecoms group) bought EE (mobile phone operator) 2. 2015, AG Barr (makers of the soft drink Irn Bru) bought Funkin Cocktails (makers of cocktails and cocktail ingredients) 3. 2015, Google (search engine) bought Double Click (online advertising firm)

Type of integration: 1. BT/EE - horizontal 2. AG Barr/Funkin - horizontal 3. Google/Double Click - vertical.

What is meant by 'marginal revenue'? a) The change in total revenue resulting from selling one more or one fewer product b) The minimum revenue required to encourage a firm to produce a product c) The revenue earned from selling products that have been reduced in price d) The revenue earned from selling products that make only a small profit e) Total revenue divided by the output sold

(a) Marginal revenue is the alteration in total revenue when the quantity sold varies by one. For instance, if the number of units sold increases from 10 to 11 and total revenue changes from £100 to £110, the marginal revenue is £10. (e) is a definition of average revenue. There are no specific terms for (b), (c) or (d).

A firm's total fixed cost is £2,000. Its average cost is £7 and its average variable cost is £2. What is the firm's output? a) 250 b) 400 c) 1,000 d) 10,000 e) 18,000

(b) Average cost minus variable cost is average fixed cost (AFC). In this case, AFC is £7 - £2 = £5. AFC is total fixed cost ÷ output, i.e. £5 = £2,000 ÷ x So x = £2,000 ÷ £5 = 400.

What would eliminate a firm's supernormal profit? a) A fall in unit costs b) An entry of rivals into the market c) An increase in barriers to exit from the market d) A reduction in corporation tax e) A rise in average revenue

(b) is correct. The entry of rivals into a market would tend to increase supply and reduce revenue for incumbent firms. Such a change would be likely to eliminate supernormal profit. (a), (b) and (c) may increase a firm's supernormal profit. (d) would mean that a firm could keep more of any supernormal profit earned.

If marginal revenue is zero, what is price elasticity of demand? a) Perfectly inelastic b) Inelastic c) Unity d) Elastic e) Perfectly inelastic

(c) If marginal revenue is zero, this means that total revenue is not changing as the output sold alters. For this situation to occur, it must mean that demand is changing by the same percentage as price. Look again at Figure 3.3 and you will see that elasticity is unity at the point directly above the point at which MR = 0.

A firm increases the output it sells from 80 to 81 and as a result its average revenue falls from £8 to £7. What is the firm's new total revenue and marginal revenue? a) TR £10; MR £11.57 b) TR £567; MR £7 c) TR £567; MR -£73 d) TR £640; MR -£1 e) TR £640; MR £73

(c) The total revenue earned when 81 units are sold is 81 x £7 = £567. The total revenue earned when 80 units are sold is 80 x £8 = £640. Marginal revenue is the change in total revenue as a result of selling one more unit. In this case, £567 - £640 = £73. (Note that the change in AR applies to all units sold and not just the marginal 81st unit.)

Which group of stakeholders is usually most interested in profit maximisation? a) Consumers b) Environmentalists c) Managers d) Shareholders e) Workers

(d) is the correct answer. Shareholders buy shares in order to gain a proportion of the profits and to make a capital gain on the shares. Making as much profit as possible will reward shareholders directly and may increase the value of their shares. Consumers want low prices and high quality of products. Environmentalists want to ensure that the firm produces in an environmentally friendly way. Managers and workers seek high pay, good working conditions and job security. Some managers may also be motivated by the prestige of running a successful and expanding company.

Summer 2008 saw Britain's highest cinema attendance since 1972. The most popular film was Mamma Mia, which was first released in July 2007. By August 2008 the film, which had cost £28m to make, had taken £245m in box offices around the world, including £61m in Britain. There were thought to be three main reasons for the increase in ticket sales. One was the bad weather, which meant parents kept their children occupied during the school holidays by taking them to the cinema. Another cause was thought to be the credit crunch. When income growth slows, and particularly when it declines, people seek more affordable and escapist entertainment. The third cause was considered to be the high quality of Mamma Mia and other films. With economic activity declining and unemployment rising in 2009, some cinema chains were considering cutting ticket prices to boost attendance further. The success of such a measure would depend on the price elasticity of demand for cinema tickets and on how many seats are currently being occupied. 1. What percentage of total box-office takings for Mamma Mia had been earned in Britain in 2008? (2 marks) 2. Explain what type of income elasticity of demand the passage suggests cinema tickets possess. (3 marks) 3. Apart from income, explain three other determinants of demand for cinema tickets. (6 marks) 4. Discuss why the success of a cut in the price of cinema tickets 'would depend on the price elasticity of demand for cinema tickets and on how many seats are currently being occupied'. (9 marks)

1. 24.90% (£61m/£245m × 100%) 2. The passage suggests that the income elasticity of demand for cinema tickets is negative, i.e. demand for the product rises when income falls. The passage mentions that when income falls people 'seek more affordable and escapist entertainment' so, at certain times, cinema tickets may be an inferior good. We are not told how high this negative income elasticity of demand might be. 3. Three other determinants of demand for cinema tickets are price, weather and the quality of the films. A rise in the price of cinema tickets would be expected to lead to a contraction in demand. A period of bad weather in the summer months may result in more people visiting the cinema in search of entertainment in a dry environment. A rise in the quality of films would be likely to attract more visits to the cinema. 4. A cut in the price of cinema tickets would be likely to result in a rise in the quantity demanded. Whether revenue would rise, or not, would depend on price elasticity of demand. If demand is relatively elastic, demand would extend by a greater percentage than the fall in price and, as a result, revenue would rise. If, however, demand is relatively inelastic, it would not make economic sense to cut price. This is because demand would rise by a smaller percentage than the fall in price and, as a result, revenue would fall. It would also not make economic sense to cut the price of cinema tickets if the cinema was normally full or operating close to full capacity. In such a situation, more people may want to purchase tickets but it would not be possible to sell more tickets. If cinemas have had a significant number of unsold seats, however, and demand is relatively elastic, it would make sense to cut the price of the tickets. The cinema operators would nevertheless have to consider whether the increase in revenue gained from selling more tickets would exceed any extra costs arising from having more viewers. In practice, having more of its seats occupied will not add much to a cinema's costs. For instance, it does not cost any more to heat a full cinema than a half-full cinema, and indeed it may be cheaper.

Breathing Buildings is a UK firm that started in 2006 in Cambridge as a spin-out company from the University of Cambridge, as a result of a research project. It received research grants from BP, among others, and has developed natural low-energy ventilation systems which it now sells successfully to offices and schools. In 2016 Breathing Buildings is growing strongly and aims to expand its staffing to increase sales still further. 1. What advantage do you think a firm gains from being based in Cambridge? 2. Explain one advantage and one disadvantage a small firm producing a ventilation system may have over a larger one. 3. What may be motivating Breathing Buildings to expand?

1. An advantage for a firm being based in Cambridge is access to highly-skilled workers. This is an example of an external economy of scale, which you will study in Topic 4. 2. A small firm producing a ventilation system may be more flexible than a large one. There will be fewer people to consult before a decision is made. A small firm, however, will be likely to have less finance to spend on research and development and marketing. 3. A desire to earn higher profits may be motivating Breathing Buildings to expand.

Newmarket in Suffolk is regarded as the home of British horse racing. Within a short distance of the town are numerous racing stables, some of which are owned and run by top trainers. The area also has a number of blacksmiths and saddlers. 1. What is the relationship between blacksmiths and saddlers and the horse racing industry? 2. Explain two external economies of scale, not related to blacksmiths and saddlers, that racehorse trainers may gain from locating their stables near to Newmarket.

1. Blacksmiths and saddlers are ancillary industries serving the racehorse industry. 2. Two external economies of scale a racehorse trainer may enjoy as a result of locating in Newmarket are access to skilled labour and the possibility of sending staff on courses at local colleges. A trainer moving into the area could attract some staff away from other stables. Local colleges may offer courses in stud and stable husbandry and equine studies.

A tale of mergers and demergers In 2008, in the middle of the financial crisis, two UK banks - the Royal Bank of Scotland and Lloyds Banking Group - were rescued by the government to prevent them from failing. Both banks had grown fast in the years before the crisis by merging with and taking over other banks. Lloyds had merged with the Trustee Savings Bank (TSB) in 1995 and with HBOS in 2008; this latter merger was attractive to Lloyds because it gained the huge mortgage business of the Halifax, but it turned out that HBOS was in trouble and this nearly brought down Lloyds. Royal Bank of Scotland had purchased NatWest bank in 2000 to become the second biggest banking group in the UK, and also expanded into the insurance sector. In 2007 it joined a consortium which purchased the Dutch bank ABN Amro. It turned out that this bank was in trouble and this purchase was one of the reasons for the failure of RBS. The UK government acquired a 43.4% stake in Lloyds and an 81% stake in RBS to enable the banks to survive. Under the competition laws of the European Commission, these purchases constituted state aid and each bank was ordered to sell off a part of its business. These are known as 'divestments' or demergers. Lloyds was ordered to sell 632 branches and it was decided that these would operate under the TSB brand. The sale took place in 2014 and the Spanish Banco Sabadell bought TSB in 2015. RBS sold 314 branches and they are due to be divested during 2016 under the name of Williams & Glyn's. 1. What were the objectives behind the RBS and Lloyds mergers in 2007/2008? 2. What might the impact of the demerger (divestment) be on various stakeholder groups?

1. Each bank was seeking to grow its market share and to acquire new types of business. For example, Lloyds was gaining Halifax's mortgage business and RBS was gaining a foothold in the Dutch market. 2. The divestment will make the banks smaller and less able to diversify, thus increasing their risks; but it might make them easier to manage and control and also easier for the government to sell back to the private sector. It will be confusing for customers but will increase the amount of competition in the market. It will threaten the jobs of some staff.

Starbucks, the Seattle-based coffee multinational company, built up its business in the 1990s and early 2000s into a leading position in coffee shops. It has grown fast since then and now has more than 17,000 branches in over 50 countries. Starbucks prides itself on its ethical approach. It is involved in community policy by sponsoring volunteer programmes and supports young people to acquire the skills and training they need to order to get ready for work. It uses ethical sourcing and responsible growing practices and it is committed to responsible environmental behaviour, including recycling, renewable energy and water conservation. CEO Howard Schultz says that its financial performance is coupled with responsible towards its people and that it is a 'world-class company with a conscience' (Starbucks, 2014). 1. Explain what appear to have been Starbucks' main objectives before 2009. (3 marks) 2. Identify an objective that firms may pursue that is not referred to in the passage. (1mark) 3. Explain why practising ethical sourcing and responsible environmental behaviour might reduce Starbucks' profit in the short run. (4 marks) 4. Identify three groups of people who may influence the objectives pursued by Starbucks. (3 marks) 5. Discuss whether 'profitability' and 'an ethical approach' can be compatible over time. (9 marks)

1. Starbucks' main objectives before 2009 appeared to be sales maximisation and increasing market share. The company was growing in size by opening more branches across the world. 2. One objective not referred to in the passage is profit maximisation. Starbucks could have grown in size and sales at the expense of a lower profit - we are not told. 3. Practising ethical sourcing and responsible environmental behaviour may increase Starbucks' costs of production in the short run. It may mean paying farmers more for coffee beans and this will raise the firm's raw material costs. Environmental policies might also include avoiding the use of chemical fertilisers or investing in cleaner waste disposal at the coffee shops; these would both increase cost at the expense of profit. 4. Managers, employees and environmental groups are three examples of stakeholders who might influence Starbucks' objectives. 5. Whether profitability and an ethical approach can be compatible over time will depend on what happens to the firm's costs and revenue. Ethical sourcing may result in the production of higher-quality coffee beans so that, while Starbucks pays the farmers more, it gets better-tasting coffee. Starbucks can advertise its corporate responsibility programme, and this might attract more customers who are interested in ethical matters - in other words, Starbucks can use its environmental credentials as a marketing device. Sponsoring volunteer programmes and supporting youth training could help Starbucks in its future recruitment and it will be able to employ young people with suitable skills. Providing health insurance for its workers will involve a cost for Starbucks, but healthy people are likely to have less time off work and to be fitter while at work. Higher labour productivity may more than offset the health insurance cost and so reduce unit labour costs. Enabling its workers to buy shares at a discount may also raise labour productivity as workers may work harder, knowing that the dividends they receive and the price of their shares may increase if the firm does well. Adopting an ethical approach may also raise revenue. Demand for the coffee may increase because its quality may rise and consumers may be attracted by the firm's ethical policy. Recent years have seen an increase in demand for fair trade products, including not only coffee but also fruit and vegetables.

LEGO, the children's toy manufacturer, was founded in 1932 by a Danish carpenter. Over the last 80 years it has grown from a small workshop to a global enterprise that is now one of the world's largest toy manufacturers which sells its products in more than 140 countries. Its headquarters are in Denmark and its main offices are in the USA, UK, China and Singapore. The firm has, however, experienced difficulties in the recent past. In 2004 it made a loss of £42 million and nearly went out of business. Its managing director blamed the loss on the company taking its eye off its core business, toys. As a result it sold off its theme parks, including Legoland near Windsor, and licensed out its non-core products. It also increased its spending on new product development and expanding the range of toys to very young children and to adults. The firm tries to change 60 per cent of its range every year and has recently brought out robotic kits for adults and a Lego kit for 2-year-olds. In 2009 the LEGO Group announced a multi-year partnership with Disney Consumer Products in which it obtained exclusive rights to construction toys based on the Disney and Disney Pixar portfolios. In 2015 the offshore wind farm, Borkum Riffgrund 1, opened and is 32 per cent owned by the LEGO Group. 1. Did Lego grow internally or externally? Briefly explain your answer. (2 marks) 2. Explain the reasons for LEGO's losses in 2004 and how it dealt with the problem. (3 marks) 3. Identify two advantages of a firm concentrating on its 'core business'. (4 marks) 4. Why might a toy manufacturer seek to target the adult market? (4 marks) 5. Discuss why a small manufacturer may be able to survive in the toy market. (7 marks)

1. From the information given, it appears that Lego has grown internally, from a small workshop to a global enterprise; it 'sells its products in more than 140 countries'. 2. The main reason for LEGO's losses in 2004 was that it stopped concentrating on its core products in which it specialised, namely toys - it had also invested in theme parks, which was a type of conglomerate integration. It probably had less knowledge of this product and market, and so its costs were higher. It divested its theme parks and its non-core product in order to specialise in what it did best. 3. Two advantages of a firm concentrating on its core business are that it may be easier to manage the firm and it may enable the firm to develop greater expertise in the narrower range of products. It develops specialist knowledge in the product and the market, and is better placed to deal with changes that arise in the external environment. 4. A toy manufacturer may seek to target the adult market in order to increase the size of the toy market. Many adults have considerable purchasing power. As their incomes rise, they spend more on leisure products, and some adults spend relatively large sums on computer games. In addition, adults buy toys for children so children can be targeted via adults. 5. A small manufacturer may be able to survive in the toy market for a number of reasons. One is that it may be producing a very specialised toy for which there is only a small (i.e. niche) market. Large firms may lack the financial incentive to provide such a toy. Some luxury toys, such as hand-made rocking horses, may also have a small market. A small toy manufacturer may be quicker to respond to changes in demand for toys as there are fewer people to consult before decisions can be made. The costs of production of a small toy manufacturer may also be lower than those of a larger manufacturer if economies of scale are not significant in producing the toys made and if workers are prepared to accept lower wages to work for a small firm. A small toy manufacturer may also produce toys under contract from a larger manufacturer, or may combine with other small manufacturers to produce a range of toys. However, small firms may find it difficult to remain in the toy market. This is because economies of scale enable larger firms to benefit from lower costs of production and they may buy out successful smaller rivals. They have large marketing budgets and they can advertise their products in the media; small firms cannot compete in this way.

Greggs, the high street baker, was founded in the 1930s as a family bakery on Tyneside. It became a limited company in 1984 and in the 1990s grew rapidly as a result of acquisitions, including the purchase of the retail outlet Bakers Oven in 1994. It has a vertically integrated supply chain with 12 bakeries, one distribution centre and one manufacturing centre. In 2016, Greggs has more than 1,698 shops and it believes that the convenience of its locations is key to its success. Its other great strength is the high quality of its food, which is fresh every day. Food on-the-go is a growing market. Greggs' costs were well controlled in 2015, one of the reasons being low global commodity costs which kept food input costs down. In 2015 the company achieved sales of £836m and a profit of £73m, which represented a 25 per cent increase on the previous year. 1. Explain why Greggs acquired Bakers Oven. (2 marks) 2. State two benefits gained by Greggs as a result of having a vertically integrated supply chain. (2 marks) 3. What effect might a rise in Greggs' profits have on the number of firms in the food on-the-go industry? (3 marks) 4. Discuss the effect that a decrease in the cost of flour would have on the profitability of Greggs' bread rolls. (7 marks) 5. Calculate: a) Greggs' profit in 2014. (2 marks) b) the percentage of profit on sales in 2015. (1 mark)

1. Greggs bought Bakers Oven in order to take over a competitor and increase its own market share. Bakers Oven may have had some successful methods and products which Greggs could take advantage of. 2. A vertically integrated supply chain enables Greggs to control the quality of the inputs it uses and also to ensure that deliveries are organised efficiently so that all shops have fresh food on time every day. 3. If Greggs are seen to be making a high profit, other firms will be attracted to the food-on-the-go sector and will enter the market to compete. The new competitors will hope that Greggs are unable to satisfy all the potential market and they will hope for their own market share. 4. A decrease in the price of flour will reduce the cost of making the bread rolls, other things being equal. Assuming that other costs and the selling price remain the same, Greggs' profits will rise. The extent to which this will happen depends on the proportion of total cost accounted for by flour. 5. a) Greggs profit in 2015 was 25% more than in 2014 so the 2014 profit was 25%, lower:(£73m × 100) ÷ 125 = £58.4m (To calculate this, you have to treat the 2015 figure as 125% and then find out what the 100% figure (2014) was.) b) The percentage of profit on sales in 2015 was(73 × 100) ÷ 836 = 8.7%

In 2014, International Airlines Group (IAG), the company which owns British Airways, reported that its profits had doubled to just over £1bn. This rise was due to the use of new fuel-efficient aircraft and to a cut in jobs and salaries at the Spanish airline Iberia, which is also part of the group. 1. What happened to the relationship between IAG's revenue and costs in 2014? 2. Explain how the job cuts at Iberia might result in a fall in the airline's profits.

1. IAG's profits rose, which means that its revenue remained above cost over the period and that the gap between the two widened. 2. A cut in jobs, whether cabin or ground crew, might result in a poorer customer service. This might result in a fall in sales as people begin to choose airlines which give a better service. Unless costs can be cut further, profits will fall.

The Co-operative Bank says that it has turned away over £1.4bn of business since implementing its first Ethical Policy in 1992. It does not use customers' money to finance businesses or organisations that go against their values and ethics in terms of the environment, human rights or animal welfare. It found that 84% of its customers choose to bank with it because of its Ethical Policy. 2014 was the first full year of operation for the Co-operative Bank after its separation from the Co-operative Group. In that year it made a loss of £264.2m and it expects to be loss-making in 2015 and 2016. It accepts that it must cut costs, including reducing the number of its branches, but it takes its values and ethics into account in all the decisions it takes. 1. Is the Co-operative Bank making a loss as a result of its ethical approach? Explain your answer. 2. How well do you think the Co-operative Bank is balancing the needs of its various stakeholder groups? 3. Apart from ethical or environmental reasons, why might a bank turn down business?

1. It is hard to know whether the Co-operative Bank's losses are attributable to the fact that it turns down business. Since 84% of its customers support its ethical approach, it might lose sales and also profits if it accepted unethical business. 2. The Co-operative Bank is keeping its customers happy, but its members and investors will not be satisfied with the fact that it is not making a profit. Its employees will be afraid that branch closures will mean redundancies. Environmental groups will support its stance. 3. A bank may turn down business if it thinks that it will not be profitable. It would be unlikely to want to provide a service that would cost it more to supply than it can earn from its sale.

Sainsbury's, the UK supermarket chain, reported a 0.1% increase in sales in the first quarter of 2016; this is the first time in more than two years that Sainsbury's has achieved a growth in sales. (Note that annual sales for 2015 were approximately £23,000 million (i.e. £23 billion.) Online sales showed the biggest growth, and clothing and entertainment products also did well. Chief Executive Mike Coupe said that these positive sales figures were achieved by good service and availability and by the policy of concentrating on lower prices on a regular basis rather than relying on promotions. In 2015 Sainsbury's made a loss of £72m, partly due to a writing-down of the value of some of its stores and amid fierce competition within the UK grocery market. Like-for-like sales (assuming the same store space) fell by 1.9%. 1. Explain two benefits that Sainsbury's managers may experience as a result of the increase in sales. 2. Explain how two groups of stakeholders, apart from managers, may have benefited from the growth of Sainsbury's sales. 3. Identify one group of stakeholders who may be concerned for their future as a result of the changing pattern of sales at Sainsbury's. 4. Consider whether Sainsbury's should be worried about its profit situation.

1. Managers may have received a pay rise as a result of the increase in sales, especially after a period of falling sales. 2. Workers and suppliers are likely to have gained from the growth of Sainsbury's. Workers may have experienced more job security and possibly promotion if more workers were hired. Suppliers of the cheaper products may have gained more custom. 3. Shareholders will certainly be worried about the 2015 loss because they will not receive a dividend for the year and the value of their shares may have fallen. 4. Sainsbury's will realise that their loss is due to the economic situation and the amount of competition but they will be anxious to get back into profit. Note that a rise in sales of 0.1% may sound quite small but, when we consider that annual sales for 2015 were £23 billion (i.e. 23 plus 9 zeros), this small percentage is actually a very large figure: 0.1% of £23 billion is £23 million.

One day a firm sells 30 bottles of perfume and receives £1,350 in revenue. The next day it sells 31 bottles and receives £1,364. 1. What is the total and average revenue on day 1? 2. What is the total, average and marginal revenue on day 2?

1. On day 1, total revenue is £1,350. Average revenue is £1,350 ÷ 30 = £45. 2. On day 2, total revenue is £1,364. Average revenue is £1,364 ÷ 31 = £44. Marginal revenue is £1,364 £1,350 = £14.

At the start of 2016, Tata Steel announced plans to sell its steel business in the UK, with the loss of more than 1,000 jobs on top of the more than 2,000 jobs that it cut during 2015. Tata's UK operations are not doing well and the Port Talbot plant is said to be losing £1m every day. There is a worldwide glut of steel and prices have fallen; Chinese steel is cheap and undercuts steel made in the UK and the EU. In addition, steel manufacture uses a lot of energy and energy prices are relatively high in the UK. The UK government is hoping to find a buyer for Tata's UK business and is aware that it might have to invest public funds to make a deal more attractive. 1. Tata is making a loss. What does this mean? 2. Explain the problems being faced by the UK steel industry. 3. Why might the UK government be prepared to subsidise a loss-making industry?

1. The revenue obtained by Tata for selling its steel is less than the cost of producing it. 2. The UK steel industry is facing problems from both sides of the market. It cannot sell enough steel because its prices are not competitive with Chinese steel and because the global demand for steel has fallen. Its costs are high because of the high cost of energy. 3. The UK government might subsidise a loss-making industry in order to keep the steel industry alive in the country as it is a basic raw material and of strategic importance. The move would also save jobs in an area of high unemployment.

Unilever is an Anglo-Dutch multinational which produces more than 400 different products, including frozen foods, soap and hair products. In 2015, the group acquired REN Skincare, a British niche skincare brand; Kate Somerville Skincare, a prestige brand; and the Italian premium ice-cream manufacturer GROM. 1. Identify reasons for these purchases by Unilever. 2. What type of integration is being practised by Unilever? Record my answers in my Blog

1. Unilever is both moving upmarket (these are premium and prestige brands) and engaging in geographical expansion. It is extending its skincare range without having to develop new products itself. This is a type of product which has a high positive income elasticity of demand. Over time incomes tend to rise, so it would be expected that sales of skincare products would increase. 2. This is conglomerate integration.

In the UK fish and chip market there are thousands of individual operators. In 2003 James Low entered the market. By 2008 his Deep Blue Restaurants chain had become Britain's biggest fish and chip shop chain serving 3m chip portions and 1.7m fish portions. Its total revenue from selling chips was £3m and from fish was £8.5m. Low believed there to be considerable advantages in running a large fish and chip shop chain, the main one being the ability to take advantage of purchasing economies. The firm bought 450 to 500 tonnes of fish a year, most of it cod, and was able to negotiate much cheaper contracts for insurance and other services. This enabled the firm to buy high-quality fish and potatoes while keeping its unit costs low. The firm emphasised the sustainability of its fish supplies. It sourced them from the Barents Sea where the fish was highly managed in fish farms. The firm set itself the target of having 60 shops by 2012 and a turnover of £25m. In 2009 the average customer spent £6.45. By 2012 it expected its customers to buy more portions and to select more expensive pieces of fish. The firm was considering ways to differentiate itself and was considering delivering fish and chips in order to compete with pizza delivery chains. 1. Define 'unit cost'. (2 marks) 2. Apart from purchasing, explain two other types of economies of scale a large fish and chip shop chain may be able to enjoy. (4 marks) 3. What was the average revenue that Deep Blue received from selling fish in 2008? (2 marks) 4. From the information given, explain two objectives that Deep Blue may have been pursuing. (4 marks) 5. Identify a fixed and a variable cost that could be involved in running a fish and chip shop. (2 marks) 6. Discuss what Deep Blue was expecting to happen to its total and average cost between 2009 and 2012. (6 marks)

1. Unit cost is the average cost of production. It is total cost divided by output. 2. A large fish and chip shop chain may be able to take advantage of financial and management economies of scale. Large firms usually find it easier to borrow from banks and may be charged a lower rate of interest per pound borrowed. When a fish and chip shop chain reaches a certain size, it may decide to issue shares. This will provide it with another source of external finance. As a firm grows, it can also employ more specialist staff. A large fish and chip shop chain may hire a marketing specialist, an accountant and a specialist buyer. 3. The average revenue was £8.5m ÷ 1.7m = £5 4. Deep Blue appeared to be aiming for growth. It had set itself the target of opening 31 more fish and chip shops by 2012. It might also have been aiming for sales revenue maximisation as there is a reference to the firm seeking to raise its turnover to £25m. Deep Blue seems to have been pursuing an ethical approach by buying fish from what appeared to be a sustainable source. 5. A fixed cost that may be involved in running a fish and chip shop is rent of the shop. A variable cost is the cost of the potatoes for chipping. 6. Deep Blue was expecting its total cost to increase between 2009 and 2012.This was because it was planning to open more shops and to sell more fish and chips. This expansion would increase rent, wages and the quantities of cooking oil, fish and potatoes purchased. Deep Blue, however, was expecting its average cost to fall. This was because it was anticipating that, by growing, it would be able to take greater advantage of economies of scale. It would have been aware that its costs might be affected by a range of other factors including a disease affecting potatoes and a change in wage rates. There was also the possibility that if Deep Blue grew very large it might experience diseconomies of scale but, at the time of writing, it was likely to be some time before it ran this risk.

1. If total cost is £423 and fixed cost is £40, what is variable cost? 2. Fixed costs are £56 and variable costs are £886. What is total cost? 3. Total cost is £400 when output is zero. What is variable cost?

1. VC = TC - FC: £423 - £40 = £383 2. TC = FC + VC: £56 + £886 = £942 3. Variable cost is 0 as the cost that is experienced when output is 0 is fixed cost.

Demergers

A demerger takes place when a firm divides into two or more parts or when it sells off part of its business. The demerger may be full or partial. - A full demerger results in a situation where the new firms are independent and do not have any direct connection with each other. - A partial merger means that the parent company retains some of the shares in the demerged business. The directors of a company may recommend a demerger for a number of reasons; we can understand these by focusing on the reasons why some firms do not want to grow. - Concentrating on a smaller range of products may enable a firm to become more expert at producing the products and to gain a stronger reputation for good quality. This explains why conglomerate mergers are now less popular than they used to be. - Producing on a smaller scale may also eliminate some diseconomies of scale, particularly in terms of managerial and industrial relations diseconomies of scale (see Topic 4). - It may be easier to manage a smaller, less diversified firm, and the relationship between workers and managers might be better in an organisation with a smaller workforce. Demergers sometimes take place because they are enforced by a country's competition authorities. You will consider the example of the Royal Bank of Scotland and Lloyds Banking Group in Activity 4.

Firms

A firm is a business organisation. It may be a large multinational company (MNC), for instance the French Carrefour group, or a small business owned by one person, for example a retail florist. An MNC has production units in more than one country. For example, Carrefour has many supermarkets throughout the world including in Argentina, Dubai, South Africa and the UK. By contrast, a florist may be a sole trader who owns only one shop. Many firms fall between these two extremes. For example, Barratt Homes is a large house-building company, with 25 divisions, but it operates only in the UK. Leekes is a medium-size furniture store which has seven branches in South Wales, SW England and the Midlands. We will be looking further at the size of firms in Topic 2. Firms operate in an industry and in a market: - An industry consists of all the firms which product the same type of good or service. For instance, Carrefour operates in the grocery industry. - A market consists of the firms in the industry - the supply side - and the firms and individuals who purchase the product - the demand side. Note that the definition of a market is flexible. For example, we could say that Carrefour operates in the grocery market or in the convenience store market.

Constraints on business growth Size of the market

A firm is always limited by the size of its potential market. Small firms often supply a local or a niche market and they would find it hard to find a different locality or niche to expand into. For example, a neighbourhood shop is necessarily limited by the number of people who live within its radius and it might not be able to open, staff and control another shop in a different neighbourhood. Or a firm which supplies a particular spare part to a machinery manufacturer is limited by the demand for its specialised product. Larger firms are not so restricted and they can expand into different products and geographical areas. However, they too are limited by the amount of demand in the market and this in turn depends on the state of the economy. Oil prices have been very low in 2015/16, partly because of low global demand, and many oil companies have been reducing rather than growing their investment.

Which of the following internal economies of scale are likely to arise in the case of a firm making a wide range of products? 1. technical 2. by-product 3. buying 4. marketing 5. financial 6. managerial 7. risk-bearing 8. research & development 9. staff facilities 10. labour

A large firm may benefit from economies 4, 5, 6 and 9 whether it is making a narrow or wide range of products. Economy 7 is actually dependent on a firm making a wide range of products, while economies 1, 2, 3, 8 and 10 are more likely to be achieved by a firm concentrating on a smaller range of products.

Motives for growth

Although a relatively high number of new firms go out of business in their first year, some of those that survive seek to grow in size in terms of the output they produce, the assets they own and the number of workers they employ. In other words, growth of firms can be measured in terms of output, sales revenue, market share, asset value or size of workforce. One reason why managers of firms seek to expand the size of their operations is the belief that size brings more profits. As you saw in Topic 1, higher profits benefit shareholders by increasing dividends and providing capital gains. Higher profits often result in managers receiving higher salaries and bonuses, and a manager who achieves a good profit performance may have better chances of promotion. Higher profits also make it easier for a firm to raise finance for further expansion. There are a number of reasons why profits may rise with growth. In particular, as firms become larger they may be able to reduce their unit costs by taking advantage of economies of scale. A firm may open branches in different countries, choosing those where costs and taxes are lower. However, some firms grow to be too large and experience diseconomies of scale. You will study this in more detail in Topic 4, but the definitions below will be sufficient for your work on this topic. 'Economies of scale' refers to the fall in long-run costs when a firm grows in size; these may be internal or external. 'Diseconomies of scale' refers to the rise in long-run costs when a firm grows too big in size; these may also be internal or external. But profits are not the only reason for growing. As a firm becomes larger and makes more sales, it can gain a greater share of the market. This gives it greater power within that market to influence price, product design and the way the products are sold. A bigger firm faces fewer competitive pressures and may be able to gain monopoly power. As a firm grows larger, it becomes harder and more expensive for other firms to take it over - but it may more easily take over other firms. Growth is also attractive to managers, who want the higher pay, status and power of running a large and important company, irrespective of profit levels. Some firms are very successful. For example, Innocent Drinks was founded in 1998 by three friends who first sold smoothie drinks from a stall at a music festival in London. By 2008 the company was selling two million smoothies a week and earning a revenue of £76 million. In 2009 it launched its Vegpot range, which consists of gourmet vegetarian ready meals. They now sell in a number of countries. Many longer-established firms also seek to increase their size; the Coca-Cola Company, for example, continues to expand.

Which of the following may prevent a firm growing in size? a) a limited number of competitors b) high raw material costs c) the market for the product is small d) the production process offers considerable scope for mass production techniques e) unlimited entrepreneurial objectives

Answer (c) is correct. A firm will find it difficult to expand if the market for the product is small. At first the firm may be able to expand by capturing more of the market, but eventually a limit would be reached unless the market grows. Answers (b) and (c) are motives for firms to grow in order to reduce their costs; (d) would tend to encourage growth. In the case of (a), the effect of the number of competitors will depend on what is happening to the size of the market, and on the size of the competitors. A small number of small competitors in a large market may enable a firm to grow in size.

Sizes and types of firms

As you saw in Topic 1, the size of firms varies from very small to very large. Some firms begin in a small way; some of these remain small and others grow to be large. And some firms are set up as large companies from the start. As you'll see in this topic, there are various reasons why some firms seek to become large and various ways of achieving this growth; however, there are also reasons why some firms choose to remain small. Types of firms also differ in ownership and motivation. In terms of ownership, many small firms are sole traders or partnerships while most large firms are companies. (Companies are firms which have separate legal status and which are owned by their shareholders.) Most of these are privately owned but there are also organisations which belong to the public sector. In terms of motivation, many firms aim for maximum profits or maximum revenue, as you saw in Topic 1, but some are not-for-profit organisations which have other reasons for being in business. We will look at all of these areas in this topic. According to Office for National Statistics (ONS) figures, there were 2.45 million enterprises registered in the UK in March 2015. Companies and public corporations represented 66.8% of total businesses and sole traders and partnerships 29.5%. However 88% of businesses employed nine or fewer employees. The largest industry group in the UK is professional, scientific and technical firms, with 17.8% of all businesses. Geographically, London has the largest number of businesses, with 18.2% of the UK total.

Business objectives

Business objectives are the aims which a firm sets out to achieve; in other words, they are the reasons why the firm is in business. Different firms pursue different objectives, depending on several factors: - The type of business organisation.Many businesses operate in order to make a profit for their owners. For example, shareholders expect a limited company to pay them a dividend (although this is not always possible) while a one-person business needs to be able to provide an income for its owner. But some businesses operate on a not-for-profit basis. For example, private schools are usually charities and aim to provide a good service for the children while keeping the fees as low as possible for the parents. On the other hand, a workers' cooperative may be most concerned with job protection while an MNC is focused on making more sales. - The length of time the firm has been in existence.A firm which has just set up might be satisfied with breaking even at first, i.e. just covering its costs with its sales receipts. As time goes by, though, the firm becomes more established and hopes to make a good profit and perhaps to expand into new markets. - The interests of groups of people who are connected to the firm.These include owners, managers, workers, consumers, suppliers, environmental groups, the local community and the government or regulator. These are known as stakeholder groups because each is affected in a different way by the firm's operations and so has some kind of 'stake' in it. For example, the owners want the firm to make more profit so they can have a bigger income and a better return on their investment; consumers want the products to be priced lower; employees want higher wages and salaries. The firm has to take into account and balance all these claims when deciding on its overall objectives. In different firms, different stakeholder groups will be more or less powerful. - Market conditions.During difficult market conditions, for example during a period of rising unemployment and falling consumer demand, a firm is probably satisfied if it can survive by just covering its costs and perhaps making a small profit. But if the economy is expanding, it will expect to make a much bigger profit.

Equilibrium

Equilibrium is a situation which is balanced and which will not change unless and until there is a change in one or more of the variables. We can think about equilibrium both in terms of individual firms and the industry as a whole: - A firm is in equilibrium when it is producing that output which allows it to maximise profit. If it is producing fewer units, it is not taking advantage of all possible profit and has an incentive to produce more. If, on the other hand, it is producing too many units, it is making a loss on the last units and has an incentive to produce less. A firm is in equilibrium when it is maximising profits, i.e. at the point where MC = MR. - The industry in which firms are operating is in equilibrium when it contains just the right number of firms. This happens when all the firms in the industry are making normal profit. If there are too many firms, some are making a loss and will leave the market. If there are too few, these are earning supernormal profits and other firms will enter the market to compete. When all firms are making normal profit, there is no incentive either for old firms to leave or for new firms to enter. The industry is in equilibrium when all firms are earning normal profit, i.e. at the point where AC = AR.

Horizontal integration

Horizontal integration occurs when a firm expands by merging with or taking over a firm which is operating at the same stage of production and making a similar product. For example, two supermarket chains might merge or one might take over the other. The new larger company can now reduce its unit costs by taking advantage of economies of scale, but it also means that the purchasing firm (usually the bigger one) is able to eliminate a competitor from the market and gain a greater market share, keeping up with rivals and gaining more power in the market.

Total, average and marginal revenues

In return for selling their products, firms receive revenue. This is the selling price of the product minus any discounts. You need to know three ways of calculating revenue and to understand the differences between them. - Total revenue (TR): Total revenue is the total amount received during a period (a month or a financial year, for example) from the sale of all the goods or services. As output rises, so does total revenue. TR = Price per unit (P) × number of units sold (Q) Or TR = P × Q For example, if a clothing store sells 100 T-shirts at £10 each, the total revenue is £10 × 100 units = £1,000 - Average revenue (AR): Average revenue (AR) is total revenue divided by the number of units sold during a given period. AR = TR ÷ number of units sold Or AR = TR ÷ Q In the above example, the average revenue is £1,000 ÷ 100 = £10 Average revenue is equal to price if all the units are sold at the same price. But sometimes firms give discounts to their customers and so the same goods might be sold at different prices. If the clothing store gives discounts on its T-shirts to regular customers, its total revenue on the 100 units sold might be £900 and the average revenue would be £900 ÷ 100 = £9 - Marginal revenue (MR): The marginal unit of any variable is the additional unit. So the marginal revenue earned by a firm is the amount of revenue resulting from selling one more unit. A more accurate way to say this is that it is the addition to total revenue resulting from selling one more unit. MR = (TR from selling x + 1 units) - (TR from selling x units) MR = Δ TR Note that the triangle is the Greek letter delta and this is used to denote a change in a variable, so Δ TR means 'change in TR'. If a firm sells all its products at the same price, then the marginal revenue will always be the same. For example, if the clothing store sells all its T-shirts at £10, each unit sold will bring in £10 and marginal revenue will always be this amount. Suppose, though, that it has sold its 100 units at £10 each but is now having trouble in selling more so it reduces the unit price to £9. The first unit sold at the lower price will earn £9, and this will be the marginal revenue, i.e. the MR of the 101st unit is £9. This can be explained as follows: Revenue from selling 101 units - revenue from selling 100 units MR = [(100 × £10) + (1 × £9)] - (100 × £10) = £1,009 - £1,000 MR = £9

Total, average and marginal costs

In the course of producing their goods or services, firms incur a range of different costs, for example raw materials, wages and overheads like administrative expenses. When all these costs are added together, we have the firm's total cost. From the total cost figures, we can calculate the average cost and the marginal cost. The first part of the topic is intended to give you a basic idea of the cost identities and relationships that we will be studying. Later in this topic we will be subdividing total cost into two main types: fixed costs and variable costs. This classification is very important when we are discussing the difference between the short run and the long run. - Total cost: Total cost (TC) is the total amount spent during a period (a month or a financial year, for example) on all the costs incurred in producing or purchasing all the goods or services. As total production increases, so does total cost. TC = cost per unit × number of units sold Suppose that, over the course of a month, a clothing store buys 1,000 T-shirts for £6 each. It also pays the monthly rent on the shop of £500. The store's total cost is (£6 × 1,000 units) + £500 = £6,500. - Average cost: Average cost (AC) is total cost divided by the number of units purchased. It is sometimes called unit cost. AC = TC ÷ number of units purchased In the above example, the average cost is £6,500 ÷ 1,000 = £6.50. Average cost can rise or fall as output rises, depending on a number of factors. The average cost curve is often drawn as a U-shaped curve, which shows that average cost falls as output rises up to a point; average cost then rises again. We will see the reasons for this later. - Marginal cost: The marginal cost (MC) is the amount of cost incurred by the firm from producing one more unit. A more accurate way to say this is that it is the addition to total cost resulting from producing one more unit. MC = (TC from producing x + 1 units) - (TC from selling x units) This can also be expressed as MC =ΔΔTC In the example of the clothing store given above, suppose that it cost £6,505 to purchase 1,001 units. The marginal cost would be £6,505 - £6,500 = £5, i.e. the new total cost minus the old total cost. This is the addition to total cost as a result of purchasing one additional T-shirt. Table 4.1 shows the total, average and marginal costs of producing a digital radio. At low levels of output, average cost falls as more units are produced; it reaches a minimum of £10 and then begins to rise again. Marginal cost does something similar. (This is explained by the law of diminishing marginal returns, which is addressed later in this topic.)

Costs in the long run

In the long run all costs have to be covered by revenue. All costs are variable and there are no fixed costs. This is because, in the long run, all factors of production are variable, i.e. they can be increased or decreased. For instance, the amount paid in rent will change if more factories are rented. Short-run costs are influenced by changes in factor proportions, as we saw in the theory of diminishing marginal productivity. But long-run costs are influenced by changes in the scale of production. Economic theory normally assumes that the long-run average cost curve is U-shaped, i.e. average costs fall initially as the firm grows in size, reach a minimum point and thereafter begin to rise again as the firm becomes too big (see Figure 4.3). This is explained below under the heading of economies of scale and diseconomies of scale. In practice a firm's long-run average cost curve may be U-shaped, L-shaped or downward sloping, or even possibly upward sloping. In the case of an L-shaped average cost curve, the firm initially experiences economies of scale but reaches its minimum efficient scale of output relatively quickly. After this point, it does not benefit from any more efficiency but it does not become inefficient either as long-run average cost remains fixed at this point. The minimum efficient scale is the level of output at which the long-run average cost (LRAC) curve reaches its lowest point and ceases to fall (see Figure 4.4). At this point, no further advantage can be taken of economies of scale (see below). The minimum efficient scale varies between industries. In those industries in which large-scale capital equipment is required (e.g. oil and aircraft production), the minimum efficient scale may be at a very high level of output. Indeed, firms in these industries may never reach the minimum efficient scale level of output. So they may face a downward-sloping long-run average cost curve, as illustrated in Figure 4.5.

Topic 4 - Costs

In the previous topic you explored revenue. When deciding what output to sell, firms take into account not only revenue but also cost. In this topic you will learn how to calculate and illustrate the different types of costs facing firms. You will also consider the significance of these costs and the nature of economies and diseconomies of scale.

Summary of Revenue

In this topic you have covered total, average and marginal revenues and the relationship between them. You have considered how the nature of these revenues is influenced by the level of competition in a market. The key points are as follows: - Total revenue is the total amount of money a firm receives from selling a given output. - Average revenue is total revenue divided by the output sold. It will be the same as price if all units are sold for the same amount. - Marginal revenue is the change in total revenue when the quantity of output sold is increased by one. - Under conditions of perfect competition, a firm's average revenue and marginal revenue are equal and constant. Its total revenue rises with output. - Under conditions of imperfect competition, average revenue and marginal revenue fall with output. Total revenue rises when demand is elastic, reaches its peak when demand is unity and then falls when demand is inelastic.

Topic 2 - Firms and growth

In this topic you will consider why some firms stay small while other firms seek to grow and you will make some important distinctions about different types of ownership. You will learn to distinguish between two main methods of growth - organic growth and integration. Finally, you will analyse the different types of merger and consider the reasons for demergers.

Integration

Integration, or external growth, is a method of growing whereby a firm merges with or takes over another firm, thus creating a larger enterprise. - A merger implies that there has been agreement between the firms and their shareholders to join together on more or less equal terms to form a new company. - A takeover happens when one firm buys another firm, absorbing it into its existing company. In some cases the directors of the firm being purchased may have recommended that their shareholders accept the offer made; in others, the directors might have unsuccessfully urged shareholders to resist the bid. Integration can be sub-divided into three main types: vertical, horizontal or conglomerate.

Internal economies of scale

Internal economies of scale are the reasons why a firm may reduce its long-run average cost when it grows in size. There are several types: - Purchasing economies: large firms buy their raw materials, components and fuel in bulk and benefit from large trade discounts, which reduces the unit cost of production. - Labour economies: large firms produce a higher output and have more scope for division of labour. This enables them to break up production processes and allows workers to specialise in the jobs they do best, thus raising the workers' productivity. - Technical economies: large equipment is often cheaper to operate per unit produced than small equipment, provided that the equipment can be operated at full capacity. This is true of machinery, buildings and transport facilities, for example. Some forms of equipment are indivisible, which means that they cannot be used on a small scale and are viable only on a large scale. For example, if the smallest railway carriage has 72 seats, then a branch line service which always carries fewer than 72 passengers will never be able to enjoy a technical economy, as it is impossible to buy a smaller carriage. - By-product economies: a large firm may be able to sell or use its by-products. For example, an oil refinery may be able to sell its chemical by-products. - Selling economies: the cost of distribution is likely to be lower per unit for large firms. For example, a large lorry will not cost twice as much to run as a small lorry. - Marketing economies: large firms are likely to be able to get cheaper rates from advertising agencies. For example, the price of a full-page advertisement in a national newspaper is not twice the price of a half-page advertisement. - Financial economies: large firms can often raise finance more easily and cheaply than can small firms. This is because they are well established and have a good credit record. - Managerial economies: large firms employ managers with more specialised functions such as accounting, research and development and sales. - Research and development economies: a large firm can spread the costs of research and development over more units and can use more specialised staff. Not only can they develop new products: they can also find more efficient ways of making their product. - Risk-bearing economies: a large firm can diversify and spread its risks over a larger production. If some of its products become less popular, it can switch resources to the production of its more successful products.

Cost curves

It is most important that you understand the cost curves we are about to study as they are used a lot in microeconomic theory. We do not use the total cost curve very much. If you did draw it, it would have an upward slope from left to right, showing that total costs rise as an increasing number of units are produced. Its slope reflects the rate at which total cost is rising. You can see an example of a total cost curve in Topic 1, under profit maximisation. The average cost curve and the marginal cost curve are, however, very important and you will be using them in Topic 5 to show the point at which a firm maximises its profits. The curves drawn in Figure 4.1 reflect the numbers given in Table 4.1, where both average cost and marginal cost fell to begin with and then rose again. You will notice that the MC curve cuts the AC curve at the lowest point of the AC curve. This is explained by a simple arithmetical relationship between the concept of the average and the concept of the marginal unit. The average changes with each additional or marginal unit produced. If the marginal unit costs less than the average, then the average will fall, i.e. the lower marginal cost pulls the average down. Conversely, if the marginal unit costs more than the average, the average will rise. Go back to Table 4.1 to understand this. Look at what happens when the firm moves from producing 3 units to producing 4 units. At 3 units, the average cost was £11. The marginal cost of producing unit 4 was £7 (40 - 33). Since £7 is less than £11, the average is pulled down and, in this case, becomes £10. When marginal cost becomes higher than average cost at unit 6, average cost begins to rise again. We can restate this. When average cost is falling, marginal cost must be below average cost. When average cost is rising, marginal cost must be above average cost. When average cost is neither falling nor rising, marginal cost must be equal to average cost and this is why, in the case of a U-shaped AC curve, the MC curve cuts the AC curve at the lowest point of the AC curve. When you draw these curves, you must be sure that this happens, i.e. that AC cuts MC at the lowest point of AC. The lowest point on the AC curve is known as the optimum output. This is the productively efficient output because average cost is being minimised.

Average fixed cost and average variable cost

Just as we calculated average total cost, so we need to calculate average fixed cost (AFC) and average variable cost (AVC). Average fixed cost (AFC) is total fixed cost divided by output: AFC = TFC ÷ number of units produced For instance, if fixed cost is £320 and output is 16, then the average fixed cost is £20. As output increases, average fixed cost falls since the same figure is being divided by a higher number of units each time. The firm is spreading its overheads over a bigger production. Average variable cost (AVC) is total variable cost divided by output: AVC = TVC ÷ number of units produced Work through Table 4.7 and make sure that you understand how all the figures are derived. Remember that fixed cost is the same throughout and applies even at zero output. You will notice that average cost falls, reaches a minimum and begins to rise again. This rising trend would probably continue if we added more units to the table. The reason for this behaviour of average cost is explained later. Here is an explanation for the various figures at 2 units. Use these examples to help you re-calculate if your figures differ from ours. 1. We are given the number of units and total cost. 2. Average cost is TC ÷ number of units, so at 2 units it is £440 ÷ 2 = £220. 3. Fixed cost is the cost of producing 0 units, i.e. £240. 4. Average fixed cost is total fixed cost divided by the number of units, so at 2 units it is £240 ÷ 2 = £120. 5. Variable cost is TC - FC, so at 2 units, it is £440 - £240 = £200. 6. Average variable cost is total variable cost/number of units, so at 2 units, it is £200 ÷ 2 = £100.

The impact of demergers

Just like mergers, demergers have an impact on the businesses themselves and on their employees and customers. A demerger in effect reverses the process of acquiring a new business and is disruptive. Administrative and operational processes which spanned the whole company are now broken up into separate sections and this can lead to duplication and confusion. People who worked well together are now broken up and may find themselves covering other functions. Such a situation leads to uncertainty among staff and this causes demotivation. However, it may also create new job opportunities in the demerged divisions or branches. Demergers are also confusing for customers, who now find themselves dealing with a new provider. For example, some people who used to be Lloyds customers now find themselves banking with a subsidiary of a Spanish bank. It is very important for the company to keep their customers clearly informed about the implications of the demerger. As far as the demerged firm is concerned, there are always pros and cons, just as there are with a merger. A demerged firm may be able to avoid diseconomies of scale; on the other hand, it may suffer from not being able to take advantage of certain economies of scale. Both or all part(s) of the new divided group are now smaller and are not able to compete on equal terms with the large players in the market; on the other hand, they may be able to serve certain profitable niches.

Constraints on business growth Access to finance

Many firms have plans to expand but are unable to do so because of a lack of finance. Again, this applies more to smaller firms: they are unable to issue shares to the public and may find it hard or impossible to raise bank loans because of the high risk of lending to them. But large companies may also find it hard to access funding during a period of economic recession when lenders are trying to reduce their risks and when people do not have money to invest.

Revenue in imperfectly competitive markets

Now we will prepare a similar table but this time it will be more realistic, as the firm has to reduce its price to sell more units. The price, AR and MR fall throughout and TR rises more gradually. This applies to firms which are operating under conditions of imperfect competition. You will study this in Topic 4. Table 3.4 shows how the average, total and marginal revenue and elasticity of demand change as a firm, operating in an imperfectly competitive market, alters its output. We assume that the firm sells all its output at the same price at each level and so price always equals average revenue: P = AR. For example, when it sells three units, it charges £8 for each unit, but when it sells eight units it charges only £3 for each unit and so it makes the same total revenue of £24 in each of these two cases. Demand is relatively elastic (E>1) when price and total revenue move in opposite directions, relatively inelastic (E<1) when they move in the same direction, and unity when total revenue does not change as demand changes. Note how to calculate the price elasticity of demand. You will remember from the AS that the formula for price elasticity of demand is: PED = % change in quantity demanded ÷ % change in price We cannot calculate PED for 1 unit, since the price has not changed and we cannot work with zeros. At 2 units, the change in quantity demanded (sold) is 2 1 = 1. This is a percentage change of 100%, i.e. 1 unit as a percentage of 1 unit. The change in price is also 1, i.e. £10 £9 = £1. This is a percentage change of 10%, i.e. 1 unit as a percentage of 10 units. So elasticity = 100 ÷ 10 = 10. This is highly elastic. Note that the table simply tells us that the elasticity is greater than 1. The overall principle here is as follows. If demand is relatively price elastic, a fall in price will result in a rise in TR, since although the price is lower, the quantity demanded is more than proportionately higher. An example might be a luxury product such as a state-of-the-art mobile phone which consumers find too expensive at a higher price but which they will begin to buy in much larger numbers when price falls. Conversely, if demand is relatively price inelastic, a fall in price will result in a fall in TR since the increase in quantity demanded is insufficient to compensate for the fall in price. An example might be a cheap item such as soap which people are buying anyway - they will not buy much more if the price falls. Demand is relatively elastic when marginal revenue is positive, unity where marginal revenue is zero and relatively inelastic where marginal revenue is negative (see Figure 3.3). A firm producing in an imperfectly competitive market will have a total revenue curve that rises at first when demand is elastic and marginal revenue is positive, reaches its peak where demand is unity and marginal revenue is zero, and then falls when demand is inelastic and marginal revenue negative (see Figure 3.4).

Organic growth

Organic growth is a process by which a firm becomes bigger by expanding from inside. It opens new offices, factories, branches or shops, purchases more equipment, hires more labour and increases its output. It may widen its range of products and/or expand into new markets. For example, Marks & Spencer has grown by opening new branches and expanding into new product lines. Internal growth enables a firm to move towards its desired size at a controlled pace. It can seek to avoid excess capacity and can try to ensure that the factors of production are increased in their best combination. However, internal growth can be slow and a firm may take a long time to reach the size its wants to be. In practice, although some UK firms (e.g. M&S) have achieved their size mainly by means of internal growth, most large firms grow by means of external growth, also known as integration.

Revenue and price elasticity of demand

Revenue in a perfectly competitive market Table 3.1 shows a situation where a firm can sell increasing numbers of units at the same price. The firm charges £8 because, if it raises its price, demand will fall to zero; if it lowers its price, consumers will buy an infinite amount but it does not need to do this because it can sell all its output at £8. Here the demand is perfectly price elastic, i.e. PED = ∞ and you will see that the price, AR and MR are the same throughout. TR therefore rises in equal stages. This is a situation of perfect competition which you will study in Topic 4. Note that this is a theoretical situation which hardly, if ever, happens in the real world, but we begin with it because the calculations are easier. Next, we will look at revenue in real-world imperfect markets. Table 3.1 Notes on calculations: To find TR, we multiply price per unit by quantity sold:£8 × 1 unit = £8; £8 × 2 units = £16, etc. MR is the addition to total revenue from selling one more unit. So to find MR, we subtract the total revenue for each quantity sold from the total revenue for the next quantity sold:MR for 1 unit = £8 £0 = £8; MR for 2 units = £16 £8, etc. To find AR, we divide total revenue by quantity sold at each level:£8 ÷ 1 unit = £8; £16 ÷ 2 units = £8, etc. Figure 3.1 shows that, as output rises, the price (P), average revenue (AR) and marginal revenue (MR) remain constant at £8. Every time an extra unit is sold, total revenue increases by £8. This means that the total revenue curve is a straight upward-sloping curve, as shown in Figure 3.2.

Constraints on business growth Owner objectives

Some firms have reached a size where they just don't want to grow any more. A sole trader may find that the amount of business is bringing in a good income without too much stress, while expanding would mean more work and more worry. A larger company may wish to avoid the disadvantages of becoming too big and unwieldy; diseconomies of scale may set in, increasing costs and reducing profits.

Why some firms remain small

Some small firms remain small, either because they find it hard to grow or because they prefer to remain small. There are several barriers to growth perhaps the biggest is lack of funding. Some small firms find it difficult to obtain loans from banks because they do not have a credit history. And it is hard for them to find new shareholders as they are too small to become public limited companies. The size of the market also limits growth and there may not be enough demand for a firm's products to warrant expansion. For example, there may be a limited demand for luxury hand-made rugs. Some products, such as car and TV repair work, cannot be standardised and the firms supplying the service have to be close to customers. Firms may also be concerned that diseconomies of scale may set in at a relatively low level of output. There is more on this in Topic 4. Expansion may not be desirable. Owners of small firms may be satisfied with the current level of profit and may not want the increased pressure and long working hours that expansion may bring. They may not want to become public limited companies because this brings in other shareholders and the original owners may lose control of the firm. There are some advantages to not growing: - Small firms are more flexible and decisions can be taken more easily. This enables them to adapt more quickly to changes in the market, for example to a change in consumer tastes. - Small firms often give a more personal service and can develop a closer relationship with their customers, often catering for specialist needs. - Small firms can also supply 'niche' markets, i.e. markets where there is a limited demand for a specialist product. An example of this is a situation where a small firm supplies a large firm with a particular input or part. Note, though, that some niche markets are also supplied by large firms, e.g. Sony Classics. - A small firm may enjoy a local monopoly, for instance a shop which is the only retail outlet on a housing estate. Such a shop can charge higher prices for the convenience offered and it may also attract local workers who are willing to work for a lower wage. Again, large firms can also supply local markets; for example, Tesco Express stores are mini-markets in local areas.

Revenue maximisation and sales maximisation

The concepts of 'revenue' and 'sales' are closely linked and there are important interrelationships between them. However first we must distinguish between them: - Revenue is an identity which means the total amount of money which a firm receives from selling its products - put simply, it is price multiplied by the quantity of output sold.TR = P × Qwhere TR = Total Revenue, P = Price and Q = Quantity - Sales is an identity measured in terms of volume and is the total number of goods or services sold, e.g. the number of barrels of oil, of mobile phones or of haircuts sold. In other words, revenue is expressed in terms of the amount of money received from sales; sales is expressed in terms of the number or volume of goods or services sold to customers from which the revenue is derived. Both revenue and sales are related to market share. A firm's market share is the percentage of the total market which it supplies, measured either in terms of number of units sold or in terms of sales revenue earned. Many large firms are very interested in securing the largest percentage of a market, whether measured in terms of revenue or of sales. A firm with a large market share is big, well-known, powerful in the market and influential in government and international circles. Below we consider the maximisation of revenue or sales as an alternative objective to profit maximisation for a firm. Note that, while revenue and sales are closely linked, revenue maximisation is not the same as sales maximisation so we will consider them separately.

What is the relationship between marginal revenue and marginal cost at the profit maximising output? a) Marginal revenue is equal to marginal cost b) Marginal revenue is greater than marginal cost c) Marginal revenue is less than marginal cost d) Marginal revenue is negative whereas marginal cost is positive e) Marginal revenue is rising whereas marginal cost is falling

The correct answer is (a). Profit is maximised where MC = MR. (b), (c) and (d) would mean that MR and MC are not equal and (e) can be rejected as firms produce where MC is rising to equate with MR.

The take-over of a frozen food company by a tobacco company is an example of: a) backward integration b) conglomerate merger c) forward integration d) horizontal integration e) internal growth

The correct answer is (b). It is a conglomerate merger as the firms are making different products. In the case of answers (a), (c) and (d), the firms would be making the same type of product.

What does sales maximisation involve? a) Seeking to achieve the highest cost possible for the output sold b) Seeking to achieve the highest profit possible for the output sold c) Trying to employ as many workers as the firm can afford d) Trying to gain the highest revenue possible for the output sold e) Trying to trade as many products as possible while avoiding making a loss

The correct answer is (e). Sales maximisation involves selling the highest output possible without making a loss. (b) describes profit maximisation and (d) revenue maximisation. We can reject (a) as firms seek to keep their costs of production low rather than high. We can also reject (c) as the number of workers a firm will seek to employ will be related to the output the firm is producing and the productivity and wages of workers.

Topic 3 - Revenue

The profits that firms aim to make are the difference between the revenues they receive from sales and the costs of producing their products. In this topic you will be looking at the meanings of - and various ways to calculate - total revenue, average revenue and marginal revenue. You will also consider the relationship between price elasticity of demand and revenue.

Constraints on business growth

There are limits on the extent to which a business is able and/or willing to grow and these come under the following headings. - Size of the market - Access to finance - Owner objectives - Regulation

Internal and external growth

There are two ways in which firms can grow. One is organic (internal) growth and the other is external growth by means of integration.

Summary of Costs

This topic has focused on the nature of costs of production. The key points are as follows: - Average cost is total cost divided by output. - The marginal cost curve cuts average cost at its lowest point. - In the short run, a firm will face both fixed and variable costs. - The shape of the long-run average cost curve is influenced by economies of scale and the possibility of diseconomies of scale. - Internal economies of scale are the benefits a firm gains, in the form of lower long-run average costs, from growing in size itself. It may, for example, be able to buy in bulk and raise finance more cheaply. - Internal diseconomies of scale arise in the form of higher average costs when a firm grows too large. - External economies of scale and external diseconomies of scale arise as a result of the industry growing larger.

Vertical integration

To understand vertical integration, you need to remind yourself of the difference between primary, secondary and tertiary production: - Primary production involves the extraction of raw materials. - Secondary production is the manufacture of these materials. - Tertiary production is the service sector. Growth by vertical integration takes place when a firm grows by extending its activities from its own stage of production into a different stage. An example would be a farm (primary sector) growing its agricultural produce and selling it in a farm shop (tertiary sector). Vertical integration can be further subdivided into forward and backward. Forward vertical integration involves extension into a later stage of production, i.e. it is a movement towards the market. For example, a clothing manufacturer might integrate forwards by taking over a chain of retail shops which stock its clothes. This allows it to control the way its products are sold and to ensure that there are stockists in all parts of its market. Forward vertical integration can also help companies to keep up with competitors. For instance, breweries may buy up public houses to ensure that their own beer will be sold. Companies may also undertake this type of merger to make sure that the standard of outlets selling their products is high. A company may go one stage further than keeping up with competitors and may buy up outlets to prevent competitors selling their products there. Backward vertical growth involves expansion into an earlier stage of production, i.e. a movement towards the source of the product. For example, a steel manufacturer might integrate backwards by buying an iron ore extraction company. In this way, it controls its supplies of raw materials and ensures that it secures the best prices; this enables it to keep up with or eliminate competitors.

Diseconomies of scale

We saw above that the traditional long-run average cost curve rises after a certain point of production because of the onset of diseconomies of scale, which begin to happen when a firm becomes too large. Again we can distinguish between internal and external diseconomies of scale. - Internal diseconomies of scale: Internal diseconomies of scale are mainly associated with administrative and managerial costs. A large firm can become unwieldy to manage as there are many people to consult and there may be long lines of authority. The firm may therefore be slow to respond to changes in demand and to the activities of its rivals. Large firms can also become too bureaucratic and may have high administration costs. It can become very hard to reduce waste when the workforce is very large. For example, there may not be strict controls on the use of materials in factories and on staff efficiency in offices. In addition large firms and, particularly, large plants tend to have worse labour relations than small ones. This is thought to be because there is less contact between workers and managers than in small firms and because it takes longer to settle disputes. Since the financial crisis, large banks have been criticised for growing too large and being unable to manage their risks and their costs. These are seen as diseconomies of scale. -External diseconomies of scale: External diseconomies of scale happen when the industry grows too large, and some of these affect the people who live in the area in which the industry is based. Congestion and pollution are examples. A growing industry may also mean increased competition for resources. This may raise the price of resources and so push up costs for all the firms in the industry.

ArcelorMittal is a leading global steel and mining company with a presence in 60 countries. Over the years it has taken over a number of rival firms, which has reduced the extent of the competition. The firm does, however, experience regular fluctuations in demand for steel. These fluctuations lead to frequent changes in the price of steel. Since 2013, steel and other commodity prices have been low because of low global demand. In 2007 ArcelorMittal announced a profit of $19.4bn; in 2015 it made a loss of $7.9bn. From the information given, consider the main objectives of ArcelorMittal.

You probably noted that the objective pursued by ArcelorMittal appears to be profit maximisation but in practice this may mean loss minimisation at present. It is probably able to use past profits to see it through the difficult period of low prices. The firm also seems to have aimed at growth, as it has taken over rival firms in the past.