IGCSE | Economics | Notes | Unit 4
The private firm as producer and employer
1. Notes for Sole Trading & Partnership
2. Multinational Businesses
3. Cooperative Business
4. Franchising Business
5. Perfect Competition & Monopoly (Advantages & Disadvantages)
6. Price Discrimination
7. Oligopoly Market with features
8. Organizing Productions
9. Economic Objectives of Firms

Unit 4: The private firm as producer and employer

1. Notes for Sole Trading & Partnership

SOLE TRADER

Meaning of Sole Trading:

A sole trader is a business that is owned by one person. It may have one or more employees. It is the most common form of ownership in the UK.
The main advantages of setting up as a sole trader are:

  • Total control of the business by the owner.
  • Cheap and easy to start up – few forms to fill in and to start trading the sole trader does not need to employ any specialist services, other than setting up a bank account and informing the tax offices.
  • Keep all the profit – as the owner, all the profit belongs to the sole trader.
  • Business affairs are private – competitors cannot see what you are earning, so will know less about how the business works and how it succeeds.

The reasons why sole traders are often successful are:

  • Can offer specialist services to customers – e.g. appliance repair specialists.
  • Can be sensitive to the needs of customers – since they are closer to the customer and will react more quickly, because they are the decision makers too.
  • Can cater for the needs of local people – a small business in a local area can build up a following in the community due to trust – if people can see the owner they feel more comfortable than if the owner is in some far off town, not able to hear the views of the local community.

The main disadvantages of being a sole trader are:

  • Unlimited liability – see below.
  • Can be difficult to raise finance, because they are small, banks will not lend them large sums and they will not be able to use any other form of long-term finance unless they change their ownership status.
  • Can be difficult to enjoy economies of scale, i.e. lower costs per unit due to higher levels of production. A sole trader, for instance, may not be able to buy in bulk and enjoy the same discounts as larger businesses.
  • There is a problem of continuity if the sole trader retires or dies – what happens to the business next?

 

PARTNERSHIP FIRM

Meaning of Partnerships
A partnership is a business where there are two or more owners of the enterprise. Most partnerships are between two and twenty members though there are examples like John Lewis and some of the major world accountancy firms where there are hundreds of partners.

A partner is normally set up using a Deed of Partnership. This contains:

  • Amount of capital each partner should provide (i.e. starting cash).
  • How profits or losses should be divided.
  • How many votes each partner has (usually based on proportion of capital provided).
  • Rules on how to take on new partners.
  • How the partnership is brought to an end, or how a partner leaves.

The advantages of a sole trader becoming a partnership are:

  • Spreads the risk across more people, so if the business gets into difficulty then there are more people to share the burden of debt
  • Partner may bring money and resources to the business (e.g. better premises to work from)
  • Partner may bring other skills and ideas to the business, complementing the work already done by the original partner
  • Increased credibility with potential customers and suppliers – who may see dealing with the business as less risky than trading with just a sole trader

For example, a builder, working originally as a sole trader, may team up with an architect or carpenter to form a partnership. Either would bring added expertise, but also might bring added capital and/or contacts. Of course the builder could team up with another builder as well – sharing the risk, and potentially the workload.

The main disadvantages of becoming a partnership are:

  • Have to share the profits.
  • Less control of the business for the individual.
  • Disputes over workload.
Problems if partners disagree over of direction of business.

 

Partnership Deed

Before starting a partnership business, all the partners have to draw up a legal document called a Partnership Deed of Agreement.
It usually contains the following information:

  • Names of included parties - includes all names of people participating in this contract
  • Commencement of partnership- includes when the partnership should begin. The date of the contract is assumed as this date, if none is given.
  • Duration of partnership - includes how long the partnership should last. It is automatically assumed that the death of one of the contracting parties breaks the contract, unless otherwise stated.
  • Business to be done - includes exactly what will be done in this partnership. This section should be very particular to avoid confusion and loopholes.
  • Name of firm - includes the name of the business entity.
  • Initial investments - includes how much each partner will invest immediately or by installments.
  • Division of profits and losses - includes what percentages of profits and losses each partner will receive. If it is not a limited partnership, then there is unlimited liability (each partner is responsible for all partners' debts, including their own).
  • Ending of the business - includes what happens when the business winds down. Usually this includes three parts: 1) All assets are turned into cash and divided among the members in a certain proportion; 2) one partner may purchase the others' shares at their value; 3) all property is divided among the members in their proper proportions.
  • Date of writing - includes simply the date that the contract was written.

Business organization – Limited Companies

Meaning of Limited company:

A limited company is a business that is owned by its shareholders, run by directors and most importantly whose liability is limited.

Limited liability means that the investors can only lose the money they have invested and no more. This encourages people to finance the company, and/or set up such a business, knowing that they can only lose what they put in, if the company fails.

For people or businesses who have a claim against the company, “limited liability” means that they can only recover money from the existing assets of the business. They cannot claim the personal assets of the shareholders to recover amounts owed by the company.

To set up as a limited company, a company has to register with Companies House and is issued with a Certificate of Incorporation. It also needs to have a Memorandum of Association which sets out what the company has been formed to do, and Articles of Association which are internal rules over includingwhat the directors can do and voting rights of the shareholders.

Limited companies can either be private limited companies or public limited companies.

The difference between the two are:

Shares in a public limited company (plc) can be traded on the Stock Exchange and can be
bought by members of the general public. Shares in a private limited company are not available to the general public;

The issued share capital of a plc (the initial value of the shares put on sale) must be greater than £50,000 in a plc. A private limited company may have a smaller share capital.

A private limited company might want to become a “plc” because:
Shares in a private limited company cannot be offered for sale to the general public, so
restricting availability of finance, especially if the business wants to expand. Therefore, it is attractive to change status.

It is also easier to raise money through other sources of finance e.g. from banks
[Note: becoming a “plc” does not necessarily mean that the company is quoted on the Stock Exchange.

The disadvantages of a being a public limited company (plc) are:

  • Costly and complicated to set up as a plc – need to employee specialist bankers and lawyers to help organise the converting to the plc.
  • Certain financial information must be made available for everyone, competitors and customers included (would you want them to know how much profit you are making?)
  • Shareholders in public companies expect a steady stream of income from dividends, which might mean that the business has to concentrate on short term objectives of creating a profit, whereas it might be better to work on longer term objectives, such as growth and investment.
  • Threat of takeover, because another company can buy up a large number of shares because they are traded publicly (can be sold to anyone). If they buy enough, they can then persuade other shareholders to join with them to vote in a new management team.

Difference Between

Public Limited company

  1. Can invite the general public to buy shares
  2. Shares are freely transferable
  3. Public companies are usually large firms
  4. Can sell shares on the Stock exchange
  5. Has ltd after it’s name

Private limited company

  1. Cannot invite public to buy shares
  2. Shares not freely transferable
  3. Usually small firms
  4. Cannot sell shares in the Stock exchange
  5. Has Pvt limited after name 

 

 

2. Multinational Businesses

What are Multinational Businesses?

Businesses which have their operations, factories and assembly plants in more than one country are known as Multinational Business. They are also known as Transnational businesses.

Advantages of being a Multinational

  • Multinational can set up their business operations in countries where the labour and raw material is cheaper, which can give them cost advantage in the international market.
  • Multinational have access to many markets which spreads the risk of failure. If any product may not be successful in a particular market, it might be successful in another.
  • MNCs produce in large quantities thus achieving greater economies of scales.
  • A multinational business is less vulnerable to trade barriers. MNCs set up their local operations in countries where there is potential market for them and get away with import duties and restrictions.
  • MNCs can locate their operations near the potential market which results in lower transportation cost.

 

Advantages of Multinational to the host country

The disadvantages of multinational company are as follows:-
(1) High Profit Low Risk Investment: The multinational company prefer to invest in areas of low risk and high profitability. Issue like social welfare, national priority etc. have less priority on their agenda. Mostly they invest in consumer goods industry.

(2) Interference in Political Matters:The multinational company from developed countries interfere in the political affairs of developing nations. There are many cases where multinational company has bribed political leadership for their own economic gains.

(3) Create Artificial Demand: These companies create artificial and unwarranted demand by making extensive use of advertising and ales and promotion techniques.

(4) Exploitation: These companies are financially very strong and adopt aggressive marketing strategies to sale their products, adopt all means to eliminate competition and create monopoly.

(5) Technological Problem: Technology they use is capital intensive so sometimes that technology does not fully fit in the needs of developing countries. Also, multinational company is criticized for transferring outdated technology to developing countries.

(6) Foreign Exchange go outside the Country: The working of multinational company is a burden on the limited resources of developing countries. They charge high price in the form of commission and royalty paid by local business subsidiary to its parent company. This leads to outflow of foreign exchange.

(7) National Threat: Sometimes outdated technology is used by domestic industries which hamper the quality and price of their products so they cannot compete with those multinational company. Hence, there is a threat of nationwide opposition to multinational company. Arrival of these companies creates an atmosphere of uncertainly to the domestic industries.

(8) Impose their Culture: Multinational company impose their culture on developing countries. Along with the products they also indirectly impose the culture of developed nations. These companies have imposed the culture of fast food and soft drinks onto the developing nations. For examples:- burger and coke.

(9) Work for Self Interest: Multinational company work toward their own self interest rather than working for the economic development of host country. They are more interested in marketing of profits at any cost.

 

3. Cooperative Business

What is a Co-operative?

A cooperative is defined as an autonomous association of persons united voluntarily to meet their common economic, social, and cultural needs and aspirations through a jointly-owned and democratically-controlled enterprise.

A co-operative is a form of business organisation that is owned and democratically controlled by its shareholders / members. The organisation is run for the mutual benefit of its shareholders / members, being the people who purchase goods or use services of the organisation, rather than being established for the purpose of earning profits for investors.
There are a number of forms of co-operative or mutual organisations, including friendly societies, credit unions and building societies as well as co-operative companies and industrial & provident societies. The key feature of all those businesses is that their main purpose is mutual support for members or the promotion of a specific purpose or social benefit.

A cooperative may also be defined as a business owned and controlled equally by the people who use its services or who work at it.
(FEATURES OF CO-OPERATIVE)

  • Every members contributes equal amount of capital.
  • Every members get equal share of profit.
  • Every members has a single voting right.
  • Every members has equal control & benefit.
  • The business will trade for a social purpose not for  profit.
  • Co-operatives are based around the concepts of self-help, self-responsibility and self-organization.
  • It is their objective to first and foremost serve members’ interests, rather than that of capital invested.

 

There are different types of co-operatives:

Housing cooperative

A housing cooperative is a legal mechanism for ownership of housing where residents either own shares reflecting their equity in the co-operative's real estate, or have membership and occupancy rights in a not-for-profit co-operative and they underwrite their housing through paying subscriptions or rent.

Building cooperative

Members of a building cooperative (in Britain known as a self-build housing co-operative) pool resources to build housing, normally using a high proportion of their own labour. When the building is finished, each member is the sole owner of a homestead, and the cooperative may be dissolved.

Retailers' cooperative

A retailers' cooperative (known as a secondary or marketing co-operative in some countries) is an organization which employs economies of scale on behalf of its members to get discounts from manufacturers and to pool marketing. It is common for locally-owned grocery stores, hardware stores and pharmacies. In this case the members of the cooperative are businesses rather than individuals.

Utility cooperative

A utility cooperative is a public utility that is owned by its customers. It is a type of consumers' cooperative. In the US, many such cooperatives were formed to provide rural electrical and telephone service.

Worker cooperative

A worker cooperative or producer cooperative is a cooperative that is owned and democratically controlled by its "worker-owners". There are no outside owners in a "pure" workers' cooperative, only the workers own shares of the business, though hybrid forms in which consumers, community members or capitalist investors also own some shares are not uncommon. Membership is not compulsory for employees, but generally only employees can become members. However, in India there is a form of workers' cooperative which insists on compulsory membership for all employees and compulsory employment for all members. That is the form of the Indian Coffee Houses. This system was advocated by the Indian communist leader A. K. Gopalan.

Consumers' cooperative

A consumers' cooperative is a business owned by its customers. Employees can also generally become members. Members vote on major decisions, and elect the board of directors from amongst their own number. A well known example in the United States is the REI (Recreational Equipment Incorporated) co-op, and in Canada: Mountain Equipment Co-op.
The world's largest consumers' cooperative is the Co-operative Group in the United Kingdom, which offers a variety of retail and financial services. The UK also has a number of autonomous consumers' cooperative societies, such as the East of England Co-operative Society and Midcounties Co-operative.
Migros is the largest supermarket chain in Switzerland and keeps the cooperative society as its form of organization.
Coop is another Swiss cooperative which operates the second largest supermarket chain in Switzerland after Migros.

Agricultural cooperative

Agricultural cooperatives are widespread in rural areas.
In the United States, there are both marketing and supply cooperatives. Agricultural marketing cooperatives, some of which are government-sponsored, promote and may actually distribute specific comodities. There are also agricultural supply cooperatives, which provide inputs into the agricultural process.
In Europe, there are strong agricultural / agribusiness cooperatives, and agricultural cooperative banks. Most emerging countries are developing agricultural cooperatives.

Advantages of a Co-operative Business
• They are usually more stable, caring and responsible employers

• They can give greater job satisfaction and variety, and encourage a strong work commitment

• They are more responsible to the customer and the community in which they operate

• If incorporated as a company or IPS will provide limited liability for individuals involved

• Co-operatives can be highly innovative and very competitive businesses -a fact that is now being recognised by the mainstream business world. .

 

4. Franchising Business

 

What is franchising?

The term "franchising" can describe some very different business arrangements. It is important to understand exactly what you're being offered.
Franchise occurs when the owner of a business (the franchisor) grants a licence to another person or business (the franchisee) to use their business idea - often in a specific geographical area.
The franchisee sells the franchisor's product or services, trades under the franchisor's trade mark or trade name and benefits from the franchisor's help and support.
In return, the franchisee usually pays an initial fee to the franchisor and then a percentage of the sales revenue.
The franchisee owns the outlet they run. But the franchisor keeps control over how products are marketed and sold and how their business idea is used.
Well-known businesses that offer franchises of this kind include Prontaprint, Dyno-Rod, McDonald's and Coffee Republic.

Advantages and disadvantages of franchising

Buying a franchise can be a quick way to set up your own business without starting from scratch. But there are also a number of drawbacks.

Advantages

  • Your business is based on a proven idea. You can check how successful other franchises are before committing yourself.
  • You can use a recognised brand name and trade marks. You benefit from any advertising or promotion by the owner of the franchise - the "franchisor".
  • The franchisor gives you support - usually including training, help setting up the business, a manual telling you how to run the business and ongoing advice.
  • You usually have exclusive rights in your territory. The franchisor won't sell any other franchises in the same region.
  • Financing the business may be easier. Banks are sometimes more likely to lend money to buy a franchise with a good reputation.
  • Risk is reduced and is shared by the franchisor.
  • If you have an existing customer base you will not have to invest time looking to set one up.
  • Relationships with suppliers have already been established.

 

Disadvantages

Costs may be higher than you expect. As well as the initial costs of buying the franchise, you pay continuing royalties and you may have to agree to buy products from the franchisor.
The franchise agreement usually includes restrictions on how you run the business. You might not be able to make changes to suit your local market.
The franchisor might go out of business, or change the way they do things.
Other franchisees could give the brand a bad reputation.
You may find it difficult to sell your franchise - you can only sell it to someone approved by the franchisor.
Reduced risk means you might not generate large profits.

 

5. Perfect Competition & Monopoly (Advantages & Disadvantages)

Perfect Competition 

A situation where there are many firms competing in the market, there is lot of competition and the firm producing the best quality goods and services at lowest price will be successful.

Characteristics of Perfect Competition

Many sellers in the market : There are many sellers in the market. There is no dominating firm.

Homogeneous products :All firms produce the identical products.

Many buyers in the market :Though there are many seller in the market they cannot control the prices. They are price takers. The prices are set through the price mechanism.

Substitutes: A large variety of goods and services are available in the market, consumer has greater choice.

Perfect information : All buyers and sellers have perfect knowledge about the prices in the market.

Knowledge : Consumers has perfect knowledge about the market situation, so seller can’t exploit consumer.

Normal Profit: A perfect competitor always earn normal profit. Abnormal profit would be a temporary (short run) phenomenon, if so, it will act as a signaling function to encourage new firm to enter in to the market.

Freedom of entry and exit:

There are no barriers to entry and exit for firm:  Firms are free to enter or exit the market at their discretion. If a firm is making profit other firms may enter the market tempted by the profits.

No preferential treatment(Single price policy):

There is no preference given to any firm by government or anybody. All firms are equally treated.

Merits of Perfect Competition

  • There is optimal allocation of resources in the long run.
  • Maximum economic efficiency as no single firm can control prices. There is no wasteful excess capacity.
  • Advertising and promotional expenses are eliminated because product is homogeneous and there is perfect knowledge among the consumers.


Demerits of Perfect Competition

  • No Research and Development undertaken as the products are homogeneous.
  • Prices in perfect competition are controlled by the price mechanism. It may lead to instable income and prices due to frequent change in equilibrium prices

 

Monopoly

Monopoly means a market where there is only one seller of a particular good or service.

Characteristics

  • Only one single seller in the market. There is no competition.
  • There are many buyers in the market.
  • The firm enjoys abnormal profits.
  • The seller controls the prices in that particular product or service and is the price maker.
  • Consumers don’t have perfect information.
  • There are barriers to entry. These barriers many be natural or artificial.
  • The product does not have close substitutes.
  • Price discrimination (different price can be charged from different consumer for same product).

 

Advantages of monopoly

  • Monopoly avoids duplication and hence wastage of resources.
  • A monopoly enjoys economics of scale as it is the only supplier of product or service in the market. The benefits can be passed on to the consumers.
  • Due to the fact that monopolies make lot of profits, it can be used for research and development and to maintain their status as a monopoly.
  • Monopolies may use price discrimination which benefits the economically weaker sections of the society. For example, Indian railways provide discounts to students travelling through its network.
  • Monopolies can afford to invest in latest technology and machinery in order to be efficient and to avoid competition.

 

Disadvantages of monopoly

  • Poor level of service.
  • No consumer sovereignty.
  • Consumers may be charged high prices for low quality of goods and services.
Lack of competition may lead to low quality and out dated goods and services.

 

6. Price Discrimination

Price discrimination arises if a firm is able to charge different price to different groups of people and gain their consumer surplus. There are three conditions that have to be met in order to achieve price discrimination:

  1. The firm must be a price maker in the market - price discrimination can only take place under monopoly or monopolistic competition.
  2. The firm must be able to identify different groups of customers and know their different elasticities of demand.
  3. There can be no resale in the market between consumers. This is known as arbitrage.

Effects of price discrimination

  • Buyers lose their consumer surplus to the monopolist
  • Profits rise for the monopolist
  • Some consumers gain a good or service that they might otherwise not have been able to have

First degree price discrimination


Also known as perfect price discrimination.

The firm separates the whole market into each individual consumer and charges them the price they are willing to pay. The firm extracts all the consumer surplus and turns it into revenue. The firm will sell up to the point where AR = MC. Beyond this point the price consumers are willing to pay is less than it costs the firm to make.
Examples: haggling, bartering.

Second degree price discrimination

Occurs in markets where there is a fixed capacity so it is in the firms interest to "fill every seat", and the firm is prepared to sell at cost to achieve this. Tends to occur where there are high fixed costs. For example, it costs much the same to fly a Boeing 747 whether there is 1 passenger on it or hundreds.
The firm begins by selling at the profit maximising point (MC=MR). However this leads to spare capacity. The firm then reduces the price to P1 to sell the remainder.
Examples: theatre tickets, plane tickets (last minute tickets cost less), football tickets in lower divisions ("kid for a quid" - adds to revenue but adds little to costs).

Third degree price discrimination

This is charging different prices to groups with different elasticities. The monopolist charges a lower price to a group of people who have more elastic demand.

Examples: telephone charges (more elastic demand in evenings), rail tickets (young persons railcard - students are more price sensitive), gender pricing in nightclubs.

 

 

7. Oligopoly Market with Features

Meaning:

Oligopoly is a form of market where there is domination of a limited number of suppliers and sellers called Oligopolists. In reality, it is the Oligopoly market which exists, having a high degree of market concentration. This indicates that a huge percentage of the Oligopoly market is occupied by the leading commercial firms of a country. These firms require strategic planning to consider the reactions of other participants existing in the market. This is precisely why an oligopolistic market is subject to greater risk of connivances.

Different theories about Oligopoly Pricing:

4 main theories involved with oligopoly pricing are as follows:

  • The prices and profits associated with the concept of Oligopoly is impossible to determine, owing to problems arising in modeling mutual prices and output decisions
  • The oligopolistic business houses join hands in charging the monopoly prices and incur monopoly profits
  • Oligopoly prices and profits exist between the monopoly and competitive endpoints of the scale
  • Commercial oligopoly firms compete on the prices in an effort to equalize both the factors like in the competitive industrial sectors.
  •  

Distinct features of an oligopolistic market:

  • An oligopolistic market comprises a handful of firms, engaged in selling analogous products
  • All oligopolistic markets increase mutual dependence among the firms involved in similar competition. It also prepares businessmen to accept the outcomes arising from rivalries with respect to alterations in the production and prices of goods.
  • In near future, an oligopolistic market is likely to impose restrictions on admission, in an attempt to incur abnormal profits.
  • Each of the business houses involved with this market produces branded goods

 
Relevance of the competition between prices and non-prices:
Price Competition deals with offering discounts on the prices of a particular product or a series of products, in an attempt to generate more market demand of those products. On the other hand, Non-price Competition concentrates on several other strategies to boost up the market shares.

Price leadership: Oligopolistic market
The dominance of one firm in the oligopolistic market results in price leadership. Firms having less market shares only follow the prices fixed by leaders.

Oligopolistic competition: Effects

  • Oligopolistic competition in most cases leads to collaboration of the business firms on issues like raising the prices of various goods and subdue production process.
  • Under other given market conditions, the competition between the sellers acquires a violent form, on the grounds of lowering the prices and increasing the production.
Collaboration of various firms also brings about stabilization in the unsteady markets.

 

 

8. Organizing Productions

Q. What are the factors that determine the size of a firm?

Business Measurement

In the world around us there are some businesses which are small and some are big. But how do we categorize these businesses as big or small. We can consider the following factors:

The number of employees:

Normally large firms have more no. of employees then small firms.  But business which use more machinery and technology i.e. capital intensive may have few employees but they still might be big. Example Microsoft has less employees but still it the biggest business on earth.

The amount of capital invested:

Basically large firms have more level of capital investment then small firms. But a business which might not use a lot of investment in machinery but and involves less investment may still be big. Take the example of software companies and consultancy firms like McKenzie & Co.

The sales turnover: 

The sales turnover of a large firm is normally more than the sales turnover of a small firm. But it is not always necessary, like a business may be going through a bad phase and may not have huge sales for the time being, it may not make the business small yet.

Market share:

The market share of a large firm is normally more than the market share of a small firm. A business may not be a market leader but still may be huge whereas if the market is itself very small, a major market share always won’t make a business big.

Q.  Why some industries prefer to remain small. OR Why there are small firms available in the economy?

Ans:

  • Lack of finance: Due to lack of finance and monetary strength some firms remain small. So, they cannot prefer to adopt capital intensive technology, Modern equipment, specialization, etc. Thus some industry holds very negligible market share. So, they remain small.
  • Personal services: Some firms like to maintain personal relation with the costumer, like to offer personalized services they prefer to remain small. For eg. Doctor, lawyer, accountant, etc.
  • Local market: some firms provide services to a local market only maybe because of geographical restrictions, Local demand, act’s they remain small. For eg. A general store providing necessities.\
  • Profit sharing:  some firms don’t want to share their profit with anyone else thus they like to enjoy small firm’s size.
  • Legal formalities: Some firm doesn’t want to follow so any government’s rules and regulations, restrictions, etc. Thus they prefer to remain small.
  • New into the market: Maybe the firm is very new to the market thus cannot face tough competition with large companies so they remain small.
  • Burden of tax: Some firms doesn’t want to pay more tax to the government so they remain small to avoid paying high taxes out of taxes
  • Government benefits
  • Personal choice
  • Provide services to large firms
  • Local monopolies

 

WHY ARE SMALL FIRMS SUCCESSFUL

 
In spite of all the advantages that economies of scale brings to large firms, small firms continue to be very important

(a)Where personal services are provided
              Small firms provide many personal services. Many builders, decorators and plumbers for example are sole proprietors

(b) Where goods and services are provided for a local area
              Goods and services for just one small area may be provided by small firms. A hairdresser has to be near his customers for convenience. Small local shops are convenient for extra items needed in a hurry

(c) Where luxury goods and services are provided
               Luxury or ‘top of the market” goods are often provided by small firms. Jewellery and leather handbags  etc.

(d) Where specialised engineering goods are provided
                Engineering goods are often wanted on a one-off basis. A car firm for example may go to a small engineering firm to be provided with a special drill that will never be asked for again

(e) Where small firms group together
                Small independent shops sometimes join together in groups to buy from one supplier. The supplier can buy goods in bulk, sell cheaply to the shops in the group, and allow the shops to compete with large supermarkets. By grouping together small firms can achieve external economies of scale 

 

Q. Explain how does a firm grow?

There are two main ways in which a business can grow - internal growth and external growth.

Internal growth

Internal Growth or also known as organic growth where the business expands by opening more outlets/factories/offices gradually, investing in its existing product range, or by developing new products. This will normally be financed through the use of retained profits, bank loans or, if the business is a PLC, through the issue of shares. This is a slower and safer method of expansion than external growth.

External growth

External growth involves buying out other business and making them a part of your business. Examples are takeovers and mergers. This Involves much greater sums of money and takes place through the use of mergers and takeovers (often known as growth through amalgamation, or simply integration).

Mergers and Take-Overs

A merger occurs where two firms combine, with the consent of both groups of shareholders and Directors.
A takeover (also known as an acquisition) refers to a situation where over 50% of the shares in another company have been purchased - therefore giving the predator full control of the newly acquired company. Both mergers and takeovers are referred to as growth through amalgamation, or simply as integration.

There are several different classifications of integration:

    • Horizontal Integration: when one firm merges with another firm or takes over another one in the same industry and at the same stage of production. Example Vodafone and Hutch, OR the Nestle takeover of Rowntree

    • Vertical Integration: one firm merges or take over another firm in the same industry but at a different stage of production. There are TWO types of vertical integration:
      • Vertical Integration Backward

    A firm takes over of merges with its suppliers.
    Example: a firm making chocolate takes over a cocoa plantation. 
    Reason: there is a greater degree of control over quality of supplies & regularity of delivery.

      • Vertical Integration Forward

    A firm takes over market outlets.
    Example: a manufacturer takes over a chain of retail shops, an oil company takes over petrol stations.
    Reason: producers wish to improve quality of premises in which goods are sold and raise standard of service in these premises.

    • Conglomerate. This occurs where two firms merge which are in different industries and produce different goods - in other words, it is pure diversification. The major advantage to the new, larger firm is that it has diversified its product range and spread its risks.

     

    Mind Mapping :
    E.g.:1

    E.g.:2

     

    Type of economies of scale

    These can be classified into five categories:

    Purchasing economies:
    When business buys in large quantities, they are able to get discounts and special prices because of buying in bulk. This reduces the unit cost of raw materials and a firm gets an advantage over other smaller firms.

    Marketing economies:
    The cost of advertising and distribution rises at a lower rate than rises in output and sales. In proportion to sales, large firms can advertise more cheaply and more effectively than their smaller rivals.

    Financial economies:
    A larger company tends to present a more secure investment; they find it easier to raise finance. Banks and other lending institutions treat large firms more favorably and these firms are in a position to negotiate loans with preferential interest rates. Further, large companies can issue shares and raise additional capital.

    Managerial economies:
    A large company benefits from the services of specialist functional managers. These firms can employ a number of highly specialized members on its management team, such as accountants, marketing managers which results in better decision being taken and reduction in overall unit costs.

    Technical economies:
    In large scale plants there are advantages in terms of the availability and use of specialist, indivisible equipment which are not available to small firms. Large manufacturing firms often use flow production methods and apply the principle of the division of labour. This use of flow production and the latest equipment will reduce the average costs of the large manufacturing businesses.

    Diseconomies of Scale

    These are the drawbacks of being a big business. In other words, all the factors those lead to an increase in average costs as a business grows.
    Diseconomies include the following:

    Human relations

    It is difficult to organize large number of employees. The business might find itself spending too much on communication. There might be long chains of command and instructions will take a long to reach the desired destination. Moreover there might be distortion in the message. There will be less personal contact between decision makers and staff, which can lead to low level of morale, lack of motivation and ultimately industrial relations problems.

    Decisions and co-ordinations

    There could be coordination problems. With a larger hierarchy, both the quality of information reaching from the management to the workers and vice versa could lead to poor decision making. There would be considerable paperwork and many meetings.

    External diseconomies

    Recently, consumers have become more conscious of the activities carried out by big firms. Therefore, big firms have to spend a lot of money on environmental issues and social responsibility act. These ultimately lead to higher average cost per unit.

     

    Q. Explain the advantages of growth? Or what are the advantages of integration / merger?

    Reasons for integration
    Internal economies of scale:
        When firms are involved in mergers or takeovers, they create a much larger business which can enjoy economies of scale.
    Rationalisation:
         A successful firm may buy up a less successful frim because its share is low. And then
    Close down the inefficient parts of the business and concentrate on the efficient parts.This is called rationalisation
    Increasing market power
          When a firm takes over one of its competitors it increases its power in the market by reducing competition.It may also raise prices while spending less on improving its services to the customer..This leads to increased profits.
    Control of supplies and the sale of goods
            A takeover may allow a producer to take control of its raw material supplies or supplies of machinery and equipment it uses. The firm can then be more sure of its supplies and it may be able to keep supplies from its competitors.
    Financial reasons
             A larger firm will have more assets that can be used as security for loans or sold off to provide more funds.
    Diversification
              Integration may increase the number of goods and services sold by a firm. This is called diversification and it means that a firm will be in less trouble if there happens to be a fall in demand for one of its products.

    How can firms raise the productivity of its labour?

    1. Training workers to improve their existing skills & learn new skills.
    2. Rewarding increased productivity with performance related pay & bonus payments.
    3. Encouraging employees to buy shares in their organization. Improved productivity will help to raise profit & pay higher dividend on shares.
    4. Improving satisfaction-for example, by improving working environment, making job more interesting, involving workers in business decision making etc.
    5. Replacing old plant & machinery with new, more efficient machines and tools for workers.
    6. Introducing new production processes and working practices designed to continually reduce waste, increase speed, improve quality and raise output in all areas of a firm. This is often known as lean manufacturing but its principles can equally apply to the production of service.

    Do economies of scale always improve the welfare of consumers?

    There are some disadvantages and limitations of the drive to exploit economies of scale.

    • Standardization of products: Mass production might lead to a standardization of products – limiting the amount of effective consumer choice in the market.
    • Lack of market demand: Market demand may be insufficient for economies of scale to be fully exploited. Some businesses may be left with a substantial amount of excess capacity if they over-invest in new capital.
    • Developing monopoly power: Businesses may use economies of scale to build up monopoly power in their own industry and this might lead to a reduction in consumer welfare and higher prices in the long run – leading to a loss of allocative inefficiency
    • Protecting monopoly power: Economies of scale might be used as a form of barrier to entry – whereby existing firms have sufficient spare capacity to force prices down in the short run if there is a threat of the entry of new suppliers

    Are large organisations necessarily better organisations- explain

    Large organisations are necessarily better organisations.
    A large organisation enjoys economies of scale. It keeps its average cost low through technical economies,marketing economies, financial economies and risk bearing economies.
    It uses specialised machinery and modern techniques to increase production and productivity, which cannot be done by a small organisation. A large firm buys raw materials in bulk. Therefore it gets them at relatively lower prices .It increases its sale by salesmanship, propaganda attractive packing. It produces quality products. It increases its productivity efficiently. It gets finance easily and even at lower rates of interest because it has large assets and properties.So it can be a better organisation.

    A large firm undertakes welfare measures to the workers and their efficiency .It introduces division of labour and specialisation to a greater extent. Labour is used to the optimum level. Better organisation of labour force and increased specialisation, increase the efficiency of labour, increase labour productivity and reduce the costs of production.

    A large firm utilises the by-products. It reduces the costs and increases the profits .A large firm is fully secured with large market size It has large wide markets .it increases its revenue and profits by supplying widely. Therefore it can be concluded that large organisations are better organisations.

     

    9. Economic Objectives of Firms

    Economic Objectives of Firms

    Alternative Aims of Firms
    1. Profit Satisficing.
    · In many firms there is separation of ownership and control. Those who own the company (shareholders) often do not get involved in the day to day running of the company.

    · This is a problem because although the owners may want to maximise profits. The managers have much less incentive to max profits because they do not get the same rewards (share dividends)

    · Therefore managers may create a minimum level of profit to keep the shareholders happy but then max other objectives such as enjoying work, getting on with other workers (not sacking them)Problem of separation between ownership and manager.

    · This can be overcome, to some extent, by giving mangers share options and performance related pay although in some industries it is difficult to measure performance

    2. Sales Maximisation.
    Firms often seek to increase their market share even if it means less profit this could occur for various reasons:
    a) Increased market share increases monopoly power and may enable to put up prices and make more profit in the long run.

    b) Managers prefer to work for bigger companies as it leads to greater prestige and higher salaries

    c) Increasing market share may force rivals out of business. E.g. supermarkets have lead to the demise of many local shops. Some firms may actually engage in predatory pricing which involves making a loss to force a rival out of business

    3. Growth Maximisation.
    This is similar to sales maximisation and may involve mergers and takeovers.

    4. Long Run Profit Maximisation

    5. Social/ Environmental concerns.
    A firms may incur extra expense to choose products which don’t harm the environment or products not tested on animals.
    · Many companies who have adopted such strategies have been very successful. This has encouraged more firms to consider these over objectives, but a cynic may argue they see it as another opportunity to increase profits

    Discuss factors that affect the profitability of firms?
    The essence of profitability is a firms Revenue – Costs with revenue depending upon price and quantity of the good sold.
    1. The degree of competition a firm faces is important. If a firm has monopoly power then it has little competition, therefore demand will be more inelastic. This enables the firm to increase profits by increasing the price. However govt regulation may prevent monopolies abusing their power e.g. the OFT can stop firms colluding (to increase price)Regulators like OFGEM can limit the prices of Gas and Electricity firm
    2. If the market is very competitive then profit will be low. This is because consumers would only buy from the cheapest firms. Also important is the idea of contestability. Market contestability is how easy it is for new firms to enter the market. If entry is easy then firms will always face threat of competition, even if it is just “hit and run competition” This will reduce profits.
    3. The strength of demand is very important. For example demand will be high if the product is fashionable, e.g. mobile phone companies have been very profitable. However in recent months profits for mobile phone companies have fallen because the high profit encouraged over supply. Products which have falling demand like Spam (tinned meat) will lead to low profit for the company
    4. The State of the economy. If there is economic growth then there will be increased demand for most products especially luxury products with a high YED. For example manufacturers of luxury sports cars will benefit from economic growth but will suffer in times of recession.
    5. A successful advertising campaign can increase demand and make the product more inelastic, however the increased revenue will need to cover the costs of the advertising. Sometimes the best methods are word of mouth. For example it was not necessary for YouTube to do much advertising.
    6. Substitutes, if there are many substitutes or substitutes are expensive then demand for the product will be higher. Similarly complementary goods will be important for the profits of a company.
    7. The other aspect of profitability is the degree of costs. An increase in costs will decrease profits, this could include labour costs, raw material costs and cost of rent. For example a devaluation of the exchange rate would increase cost of imports therefore companies who imported raw materials would face an increase in costs. Alternatively if the firm is able to increase productivity by improving technology then profits should increase. If a firm imports raw materials the exchange rate will be important. An depreciation making imports more expensive. However depreciation of the exchange rate is good for exporters who will become more competitive.
    8. A firm with high fixed costs will need to produce a lot to benefit from economies of scale and produce on the minimum efficient scale, otherwise average costs will be too high. For example in the steel industry we have seen a lot of rationalisation where medium sized firms have lost their competitiveness and had to merger with others.
    9. If a firm is not dynamically efficient then over time costs will increase. For example state monopolies often had little incentive to cut costs, e.g. get rid of surplus labour. Therefore before privatisation they made little profit, however with the workings of the market they became more efficient.
    10. If the firm can price discriminate it will be more efficient. This involves charging different prices for the same good, so the firm can charge higher prices to those with inelastic demand. This is important for airline firms.