PEARSON EDEXCEL INTERNATIONAL A Student Book 2

Karen Borrington COPY Tracey Joad

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COURSE STRUCTURE IV ABOUT THIS BOOK VI ASSESSMENT OVERVIEW VIII UNIT 3: BEHAVIOUR 2 UNIT 4: DEVELOPMENTS IN THE GLOBAL ECONOMY 157 INDEX 364 COPY

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F01_IASL_ECON_39194_PRE_i-ix.indd 3 01/05/2019 10:16 iv COURSE STRUCTURE UNIT 3: BUSINESS BEHAVIOUR

TYPES AND SIZES OF MARKET GOVERNMENT 2 STRUCTURES AND INTERVENTION 140 CONTESTABILITY 54 1. TYPES OF BUSINESS 3 8. EFFICIENCY 55 19. GOVERNMENT INTERVENTION IN 2. SIZES OF BUSINESSES 7 9. MARKET STRUCTURES PRODUCT MARKETS 141 AND CONCENTRATION 3. BUSINESS OBJECTIVES 16 RATIOS 63 20. GOVERNMENT INTERVENTION IN 10. PERFECT COMPETITION 70 LABOUR MARKETS 150 11. MONOPOLISTIC COMPETITION 79 12. OLIGOPOLY 85COPY 13. MONOPOLY AND MONOPSONY 95 14. CONTESTABILITY 108

REVENUE, COSTS LABOUR AND PROFITS 22 MARKETS 113

4. REVENUE 23 15. THE DEMAND FOR LABOUR 114 5. COSTS 28 16. THE SUPPLY OF 6. ECONOMIES AND LABOUR 121 DISECONOMIES OF SCALE 38 17. THE DETERMINATION OF WAGE RATES IN 7. PROFITSSAMPLE AND LOSSES 46 COMPETITIVE AND NON-COMPETITIVE MARKETS 127 18. MARKET FAILURE IN THE LABOUR MARKET 136

F01_IASL_ECON_39194_PRE_i-ix.indd 4 01/05/2019 10:16 COURSE STRUCTURE v UNIT 4: DEVELOPMENTS IN THE GLOBAL ECONOMY CAUSES AND BALANCE OF PAYMENTS, THE ROLE OF THE EFFECTS OF EXCHANGE RATES AND STATE IN THE GLOBALISATION 157 INTERNATIONAL MACROECONOMY 282 COMPETITIVENESS 222 21. CHARACTERISTICS AND 28. BALANCE OF 34. PUBLIC EXPENDITURE 283 CAUSES OF PAYMENTS 223 GLOBALISATION 158 35. TAXATION 292 29. EXCHANGE RATE 22. THE EFFECTS OF SYSTEMS 234 36. PUBLIC SECTOR GLOBALISATION 167 BORROWING AND PUBLIC 30. THE IMPACT OF CHANGES SECTOR DEBT 301 IN EXCHANGE RATES 245 37. USING MACROECONOMIC 31. INTERNATIONAL POLICIES 311 COMPETITIVENESS 252COPY 38. IMPACT AND PROBLEMS OF MACROECONOMIC POLICIES 321

TRADE AND POVERTY AND GROWTH AND THE GLOBAL INEQUALITY 261 DEVELOPMENT IN ECONOMY 176 DEVELOPING, 23. SPECIALISATION AND 32. POVERTY 262 EMERGING AND COMPARATIVE DEVELOPED ADVANTAGE 177 33. INEQUALITY 271 ECONOMIES 329 24. PATTERNS AND VOLUME 39. MEASURES OF ECONOMIC OF WORLD 188 DEVELOPMENT 330 25. THE TERMS OF TRADE 196 40. CONSTRAINTS ON GROWTH SAMPLE AND DEVELOPMENT 339 26. TRADE LIBERALISATION AND TRADING BLOCS 202 41. MEASURES TO PROMOTE 27. RESTRICTIONS ON GROWTH AND FREE TRADE 213 DEVELOPMENT 349 INDEX 364

F01_IASL_ECON_39194_PRE_i-ix.indd 5 01/05/2019 10:16 vi ABOUT THIS BOOK ABOUT THIS BOOK This book is written for students following the Pearson a getting started activity to introduce the concepts. There Edexcel International Advanced Level (IAL) Economics is a mix of learning points and activities throughout, specification. It covers the second year of the International including global case studies that show a range of A Level qualification. examples within real-life contexts. Checkpoint questions at the end of each chapter help assess understanding of The book has been carefully structured to match the order the key learning objectives. of the topics in the specification, although teaching and learning can take place in any order, both in the classroom The content for Unit 3 is applicable to Paper 3 (Business and in any independent learning. This book is organised behaviour) and the content for Unit 4 is applicable to into two units (Unit 3 Business behaviour and Unit 4 Paper 4 (Developments in the global economy). Knowing Developments in the global economy), each with several how to apply learning to both of these papers will be topic areas. critical for exam success. There are exam questions at the end of each chapter to provide opportunity for exam Each topic area is divided into chapters to break the practice. Answers are provided online in the teaching content down into manageable chunks. Each chapter resource pack. begins by listing the key learning objectives and includes

Topic openers Learning objectives Specification reference Introduce each of the key topics Each chapter starts with a list of The specification reference is given at the start in the specification. key assessment objectives. COPYof each chapter and in the running header.

SPECIFICATION 3.3.1 1 TYPES OF BUSINESS 3

UNIT 3 1 TYPES OF BUSINESS 3.3.1 workers. However, they will have unlimited liability LEARNING OBJECTIVES due to the fact that, as a sole trader, the owner and the ◼◼ Understand different types of businesses business are one and the same. Debts of the business including private sector organisations, state- are also the debts of the owner, and the owner’s TYPES AND SIZES owned enterprises, for-profit and not-for-profit personal possessions can be taken off the owner to organisations, and joint ventures pay any business debts. A is similar in many ways to a sole trader except that there are two or more people in GETTING STARTED the partnership and so capital, risks and responsibility OF BUSINESSES are shared between the partners. The partners have Your local shopping area is likely to have different full control of the business and keep all the profit types of businesses. Write a list of the businesses in themselves. Unlimited liability also applies to the this area that are: The first part of Unit 3 is about different types of business organisations including those in the partners in the partnership. Partners are liable for the  (are any of these global companies?) actions of the other partners. private and public sector as well as those that aim to make a profit and those that do not. It  owned by the government Limited companies are businesses that have gone then focuses on different sizes of business and how they grow. This can be by the firm growing  not companies and are owned by individuals or through legal formalities to be registered, usually with or by it joining with other firms to form much larger business organisations. The benefits and groups of people. the government. With this registration comes limited Are there any charities in the area? drawbacks, and the constraints that prevent growth, are considered as well as why some liability, which separates in law the and the owners (the shareholders). This means the shareholders businesses remain small. Finally, the main objectives of businesses are analysed, including why can only lose the amount of capital they have invested firms follow such objectives. PRIVATE SECTOR ORGANISATIONS as share capital and their personal possessions are protected if the company has debts it cannot pay. The LINK Student Book 1, Chapter 5 shareholders are paid a share of the profits, assuming Private sector organisations are organisations that profits are made, and this is calleddividends . In some are owned by individuals or companies and not the countries, companies are separated into private limited state. Almost all private sector organisations aim to companies and public limited companies. make a profit. Exactly how much profit depends on In a private the other shareholders the objectives of the organisations themselves. For usually have to agree who can buy the shares and they example, a self-employed businessperson may want to can therefore only be sold to family and friends. There maximise profits. Alternatively, the businessperson may may be restrictions on the number of shares that can be prefer to make less profit and work fewer hours. In the held by any one shareholder. In some countries a private case of large companies, the owners of the company limited company will have ‘Ltd’ after its name while in are the shareholders and they will want the company other countries it will have ‘Pvt Ltd’ after its name. to make the maximum profit possible. However, it A , however, can have its is the company directors and managers that make shares traded freely on the stock exchange in its own the decisions and run the company. This means that country or even on foreign stock exchanges. In some making a profit is important, but whether it is the countries it will have ‘plc’ after its name to show it is maximum profit or something less depends very much a public limited company but in other countries it will on the motivations of directors and managers. just have ‘Ltd’ or nothing after its name. Whatever the In the private sector there are different types additions to the names of companies, if any, they all of business organisations including: sole traders, have and have a separate legal identity , limited companies and co-operatives. to their owners, the shareholders. A sole trader or sole proprietor is a business Co-operatives are businesses that are owned by where only one person owns and controls the members and each member has one vote on major business. Most businesses in the majority of countries business decisions and issues. Any profits that are are sole traders. They are easy to set up, often require made are shared out equally among the members. The little capital, and have few, if any, legal requirements. members have limited liability. The main objective of The owner has full control of the business and keeps the co-operative form of business organisation is to SAMPLEall the profit themselves. They may or may not employ provide service rather than to earn a profit.

Getting started An activity to introduce the key concepts in each chapter. Questions are designed Key subject terms are to stimulate discussion and use prior knowledge. They can be tackled by colour coded within individuals, pairs, groups or the whole class. the main text.

F01_IASL_ECON_39194_PRE_i-ix.indd 6 01/05/2019 10:16 ABOUT THIS BOOK vii

Activity Skills Each chapter includes activities Relevant exam questions are labelled with key skills, allowing for to embed understanding through a strong focus on particular academic qualities. These transferable case studies and questions. skills are highly valued in further study and the workplace.

96 13 MONOPOLY AND MONOPSONY SPECIFICATION 3.3.3 SPECIFICATION 3.3.3 13 MONOPOLY AND MONOPSONY 97

monopoly on the production of Mars chocolate bars, Average revenue Total Marginal it will also have to lower its price on the other 10 Quantity PROFIT MAXIMISING EQUILIBRIUM but the monopoly is very weak because a number of or price revenue revenue units. This is because it cannot charge a higher price competitors produce similar products. to some consumers than others (although we will see OUTPUT $ $ $ later on in this chapter that this is possible in special The neo-classical theory of the firm assumes that a REASONING 0 0 0 monopolist will be a short-run profit maximiser. This SKILLS 8 circumstances). There is a loss of revenue not just of ACTIVITY 1 1 8 8 $1 on the sale of the eleventh unit but of a further means that it will produce where MC = MR. 4 Figure 2 adds the traditional U-shaped average CASE STUDY: SINGLE SELLER? 2 6 12 $10 on the first 10 units. Total revenue increases from 0 and marginal cost curves to the average and marginal 3 4 12 $200 ($20 × 10 units) to $209 ($19 × 11 units), –4 so marginal revenue on the eleventh unit is $9 ($209 revenue curves outlined above. 4 2 8  The equilibrium profit maximising level of output is –8 – $200) while the average revenue on selling 11 units 5 0 0 is $19 ($209 ÷ 11) which is, of course, the price. 0A where MC = MR.  The price will be 0E. Buyers are prepared to pay 0E ▲ Table 1 Table 1 gives a further example of falling marginal and average revenues. Note that the fall in marginal for this output. We know this because the average revenue is twice as large over any given change in revenue curve is also the demand curve and the quantity as the fall in average revenue. This is true of demand curve shows the maximum price buyers will FIGURE 1 all straight line average revenue curves. Plotting these pay for any given level of output. figures on a diagram gives Figure 1. The marginal  Supernormal profit of EFGC will be made. The The revenue curves of a monopolist supernormal profit per unit (GF) is the difference A monopolist, being the sole supplier in the industry, revenue figures, as with all marginal figures, are plotted half way between ‘whole’ output figures, so between the average revenue received (AF) and faces a downward sloping demand or average revenue the average cost incurred (AG). 0A units are sold. curve. Marginal revenue falls at twice the rate of the marginal revenue of the second unit is plotted half way between one and two units. It can be seen that Therefore total supernormal profit is 0A× FG, or 1 How many electricity companies can you buy average revenue and becomes zero when total revenue the area EFGC. is maximised. at any given level of output, average revenue is twice electricity from in your local area? marginal revenue. Total revenue is at a maximum when Note that EFGC is supernormal profit because 2 How many airlines fly directly from your nearest marginal revenue is zero. If marginal revenue (the economic cost includes an allowance for normal main city to New York, USA? $ profit. Note also that price is not equal to the 12 addition to total revenue) becomes negative then total 3 How do you think this affects the price charged for revenue will automatically fall. Total revenue is zero if intersection of the MC and MR curves (i.e. price is electricity and flights to New York? average revenue, the price received per unit of output, 10 is zero too. FIGURE 2 8 PROBLEM-SOLVING, REASONING REVENUE CURVES ACTIVITY 2 SKILLS Profit maximising output 6 The monopolist will maximise profits by producing LINK Student Book 1, Chapter 7 REVENUE CURVES where MC = MR at 0A. It will base its prices on its average revenue curve, charging 0E. It will be able A monopoly firm is itself the industry. As the industry 4 Output (units per week) Marginal revenue $ faces a downward sloping demand curve, then so does to earn supernormal profit of EFGC because average 0 revenue is greater than average cost at this level of the monopolist. It can therefore only increase sales by 2 10 TR 1 output. reducing price, or increase price by reducing sales. It 7 can set either price or output but not both, i.e. if it sets 2 4 $ the price then the demand curve shows how many 0 1 2 3 4 5 Output 3 1 MC should be sold. If it sets the output then the demand 4 curve shows what price it needs to charge to sell all $ –2 10 5 that output. F AC The demand curve shows the quantity bought at ▲ Table 2 E any given price. For instance, a water company might 8 sell two billion litres of water at 1c per litre. This price 1 Work out the (a) total revenue and (b) average is the same as its average revenue; on average it will 6 revenue at output levels from 0 to 5 units. SUPERNORMAL (a) Draw the axes of a graph with revenue from PROFIT G receive 1c per litre, so the downward sloping demand 2 C curve facing the firm is also the average revenue curve 4 $0 to $10 and output from 0 to 5. (b) Plot the marginal and average revenue curves. (c) Extend of the firm. B If average revenue is falling, marginal revenue must 2 the average revenue curve to the output axis AR = D assuming that average revenue continues to fall at be falling too and at a faster rate. For example, assume MR MR AR = D a firm sells 10 units at $20 each. To sell an eleventh the same rate as in the table. 3 What is the value of marginal revenue when total unit, it needs to lower its price, say to $19. Not only 0 1 2 3 4 5 Output 0 A Output will it have to lower its price on the eleventh unit, but revenue is at a maximum?

Links Suggest ways that topics link to others to build on knowledge and develop synoptic skills. COPY

Exam practice Checkpoint These questions are found at the end of each chapter. They are These questions check understanding of tailored to the Pearson Edexcel specification to allow for practice and the key learning points in each chapter. development of exam writing technique. They also allow for practice These are NOT exam-style questions. responding to the command words used in the exams.

52 7 PROFITS AND LOSSES SPECIFICATION 3.3.2 SPECIFICATION 3.3.2 7 PROFITS AND LOSSES 53 THINKING LIKE AN ECONOMIST EXAM PRACTICE E.ONWARDS AND UPWARDS – A CHANGING WORLD FOR ENERGY FIRMS there was a lot of government financial support for SEARS HOLDINGS PLANS MORE THAN 100 NEW STORE renewable energy generation and wholesale electricity prices were lower than they had been, E.ON's profits CLOSURES fell by a large amount. In 2016, E.ON announced its The US retailer Sears Holdings – which operates of November 2017. The department store Macy’s said biggest-ever loss. Sears department stores and the discount Kmart it would close seven more stores as it too looks to cut However, by 2018, E.ON had changed to gaining chain – announced that it expects to close roughly costs and reduce its physical presence to survive the 80 per of its revenue from supplying electricity 100 additional stores by spring 2018, adding to the tough retail environment. to households rather than generating electricity itself. hundreds of stores it shut in 2017 as it attempts to It became one of Europe’s largest operators of power cope with the rise of ecommerce. The company said E.ON is one of the world’s largest private electric utility distribution for consumer-energy supply by number that it planned to close 64 Kmart stores and 39 Sears service providers. It used to generate electricity from of customers (50m customers). It has benefited stores between March and April, 2018. fossil fuels such as gas, coal and oil and nuclear plants from the falling cost of wind and solar power and an The once significant American retail brand has and bought additional energy from other electricity increase in demand from the rise of electric vehicles been aggressively shrinking its physical stores to generators. It also supplied electricity to households. (EVs). E.ON will take the lead in power distribution keep operating in spite of heavy losses. It has made It was ’s second-biggest company and was in Germany and consumers will move over to using more than $11bn in losses over the past seven years. very successful in achieving profits each year. This electric vehicles. Sears closed several hundred stores in 2017 and had meant it could generate its own electricity to sell Having most of E.ON’s operating revenues coming already announced last year that it planned to close to households and if demand was greater than the from gas and electricity supply to customers and another 63 Kmart and Sears stores in late January of quantity of electricity it produced, E.ON would buy not from electricity generation will ensure stable 2018. The company operated about 1100 stores as additional electricity from other companies. This revenue and higher profits. The company expects additional electricity was often at a higher cost than €600m–800m a year of cost savings from changing the electricity it generated itself but it was still at a to buying its supplies of energy from more renewable much lower cost than the price it charged customers. sources. This will compensate the decline in its Therefore, higher demand for electricity and high earnings from generating its own electricity from prices meant E.ON made a good profit. 1 Which one of the following shows that Sears is nuclear power stations. EXAM HINT After the accident at the nuclear plant at In 2018, E.ON announced a large increase in making a loss? (1 marks) Fukushima, Japan, the German government profits. Consumers pay a high price for electricity in (a) Total cost is lower than total revenue Explain why US retail stores would be forced to close announced all its nuclear power plants must be shut Germany but prices are unlikely to increase further. (b) Total cost calculated by an economist is higher using the concepts of costs, revenues and shut down down by 2022. This meant E.ON had to change the This lack of further price rises will limit future than the total cost calculated by an accountant points, and a diagram. Then explain what would have type of electricity plants it operated or buy most of increases in profit for E.ON unless it can find more (c) Normal profit is less than supernormal profit to happen if existing stores were to remain open its electricity from other companies. Even though ways to reduce its costs. (d) Total revenue is less than total variable cost in terms of costs and revenues. Is it inevitable that these events would never happen? Assess the likely 2 Explain, using the US retail industry as an example, probability that supply and demand conditions will CHECKPOINT what is meant by ‘profit’. (4 marks) change in the US retailing industry. 1 What is the difference between normal profit 4 Why is profit maximised when MC=MR? 3 Analyse why, in the short run, a US retail firm might and supernormal profit? keep stores open despite making losses. (6 marks) 5 Why might a firm not shut down in the short 2 Why does an economist consider normal profit run when it is making a loss? 4 Evaluate whether further closures of US retailing to be part of total cost? stores in 2018 were inevitable. (20 marks) 6 When will a firm shut down in the long run? 3 Why can an accountant think a firm is making a profit when an economist does not? SAMPLESUBJECT VOCABULARY long-run shut down where normal profit is not being earned profit the difference between total revenue and total cost in the long run short-run shut down where variable costs are not being loss where total cost is greater than total revenue covered normal profit the profit that the firm could make by using its supernormal profit the profit over and above normal profit resources in their next best use. Normal profit is an economic cost

Thinking like an economist Subject vocabulary Exam hint Provide opportunities to explore an An alphabetical list of all the subject terms in each Give tips on how to answer the aspect of economics in more detail chapter with clear definitions for EAL learners. A exam questions and guidance to deepen understanding. collated glossary is provided in the eBook. for exam preparation.

F01_IASL_ECON_39194_PRE_i-ix.indd 7 01/05/2019 10:16 viii ASSESSMENT OVERVIEW ASSESSMENT OVERVIEW The following tables give an overview of the assessment for this course. You should study this information closely to help ensure that you are fully prepared for this course and know exactly what to expect in each part of the assessment.

PAPER 3 PERCENTAGE PERCENTAGE MARK TIME AVAILABILITY STRUCTURE OF IA2 OF IAL BUSINESS BEHAVIOUR 50% 25% 80 2 hours January, June Section A: six multiple- Written exam paper and October choice questions (6 marks), Section B: a five-part Paper code First assessment: January 2020 question, based on data WEC13/01 provided in a source booklet Externally set and (34 marks), and Section C: marked by Pearson two 20-mark essay questions Edexcel from a choice of three (40 marks) Single tier of entry Calculators can be used

PAPER 4 PERCENTAGE PERCENTAGE MARK TIME AVAILABILITY STRUCTURE OF IA2 OF IAL DEVELOPMENTS IN THE 50% 25% 80 2 hours January, June Section A: six multiple- GLOBAL ECONOMY andCOPY October choice questions (6 marks), Section B: a five-part Written exam paper First assessment: June 2020 question, based on data Paper code provided in a source booklet WEC14/01 (34 marks) and Section C: two 20-mark essay questions Externally set and from a choice of three marked by Pearson (40 marks) Edexcel Single tier of entry Calculators can be used

ASSESSMENT OBJECTIVES AND WEIGHTINGS

ASSESSMENT DESCRIPTION % IN % IN % IN OBJECTIVE IAS IA2 IAL

Demonstrate knowledge of terms, concepts, theories and models to show an 27.5 18.8 23.1 A01 understanding of the behaviour of economic agents A02 SAMPLEApply knowledge and understanding to various economic contexts 30 22.5 26.3 Analyse issues and evidence, showing an understanding of their impact 22.5 28.8 25.6 A03 on economic agents

Evaluate economic arguments and use appropriate evidence to support 20 30 25 A04 informed judgements

Note: Percentages may not add up to 100 due to rounding.

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RELATIONSHIP OF ASSESSMENT OBJECTIVES TO UNITS FOR THE INTERNATIONAL ADVANCED SUBSIDIARY QUALIFICATION

ASSESSMENT OBJECTIVE UNIT NUMBER A01 A02 A03 A04

Unit 1 6.9% 7.5% 5.6% 5%

Unit 2 6.9% 7.5% 5.6% 5%

Unit 3 4.7% 5.6% 7.2% 7.5%

Unit 4 4.7% 5.6% 7.2% 7.5%

Total for International Advanced Level 23.1% 26.3% 25.6% 25% Note: Percentages may not add up to 100 due to rounding.

RELATIONSHIP OF ASSESSMENT OBJECTIVES TO COMMAND WORDS

COMMAND NUMBER OF MARKS MARK SCHEME AOS

Calculate 2 Points Based AO2

Draw 4 Points BasedCOPYAO1, AO2

Explain what is meant by Explain the term 4 Points Based AO1, AO2 Explain two characteristics Explain why Explain how 4 Points Based AO1, AO2, AO3 Explain the likely impact Explain and illustrate Analyse 6 Points Based AO1, AO2, AO3

Examine 8 Points Based AO1, AO2, AO3, AO4

Discuss 14 Levels Based AO1, AO2, AO3, AO4

Evaluate/To what extent 20 Levels Based AO1, AO2, AO3, AO4 SAMPLE

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UNIT 3 2 SIZES OF BUSINESSES 3.3.1 firms producing at the minimum efficient scale of LEARNING OBJECTIVES production (explained in Chapter 6) may be needed ◼◼ Understand there are different sizes of businesses to satisfy total demand. and the ways businesses grow  Barriers to entry (explained in Chapter 9) may exist ◼◼ Understand the advantages and disadvantages of which protect large firms from potential competitors. each type of merger/takeover Small firms survive for the opposite reasons: ◼◼ Understand the constraints on business growth,  Economies of scale may be very small relative to including the size of market, access to , the market size. A large number of firms may be owner objectives and government regulation and able to operate at the minimum efficient scale of bureaucracy production. Small firms may also be able to take ◼◼ Understand the reasons for some firms remaining advantage of the higher costs of larger firms in small and others growing the industry caused by diseconomies of scale ◼◼ Understand the impact of growth of firms on (explained in Chapter 6). Changing technology, businesses, workers and consumers such as the internet, can allow small firms the same ◼◼ Understand the reasons for demergers and the cost advantage as large firms in reaching out to impact of demergers on businesses, workers and customers, especially in small niche markets. consumers  The costs of production for a large-scale producer may be higher than for a small firm. In part, this may be due to productive inefficiency – a large firm GETTING STARTED operating within its average cost curve boundary Use the internet to find out about a recent merger or (explained COPYin Chapter 8). For instance, larger firms takeover. What did the two (or more) firms produce? may be poorly organised in what they see as small What were the reasons given for the merger? Is insignificant segments of the market (called market it likely to create a business with a higher value niches) or X-inefficiency (explained in Chapter 8) measured by its share price? may be present. Equally, the average cost curve of a large producer may be higher in certain markets than for a small producer. For instance, a large firm may be forced to pay its workers high wages THE SIZE OF BUSINESSES because it operates in formal labour markets, i.e. it Although production in many economies is dominated is organised and registered to pay . A small firm by large firms, there are many industries where small may be able to pay relatively low wages in informal and medium-sized enterprises (SMEs) are important. labour markets, i.e. those that are not recognised by SMEs are independent firms, not owned by another the government and do not pay tax. Indeed, owners firm, which employ fewer than a given number of of small companies can work very long hours at a employees. This number varies between countries. rate of pay per hour which they would find totally The most frequently used classification for an SME is unacceptable if in a normal job. one that employs fewer than 250 employees – this is  Barriers to entry may be low. The cost of setting the measure used by the European Union. However, up in an industry, such as the food retail industry, financial assets are also used as part of the definition may be small. Products may be simple to produce and an SME should have an annual turnover of not or sell. Finance to set up in the industry may be more than €50 million, and/or an annual Statement of readily available. The product sold may be relatively Financial Position not higher than €43 million. homogeneous. It may be easy for a small firm to A large ,SAMPLE by EU definition, is one that produce a new product and establish itself in the has more than 250 employees, an annual turnover of market. more than €50 million and/or a Statement of Financial  Small firms can be monopolists. A monopolist Position of €43 million or higher. (explained in Chapter 13) offers a product for Large firms exist for two main reasons: sale which is available from no other company.  Economies of scale (explained in Chapter 6) in the Many small firms survive because they offer a industry may be significant. Only a small number of local, flexible and personal service. For instance, a

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small local shop may have a monopoly on the sale  Horizontal integration is a merger between two of newspapers, magazines, greetings cards, toys firms in the same industry at the same stage of and stationery in a local area. Consumers may be production, for instance, the merger of two car unwilling to walk half a mile extra to buy greetings manufacturers or two bakeries. cards at a 10 per cent discount or travel 10 miles  Vertical integration is a merger between two by car to a local superstore to buy a $2 toy at a firms at different production stages in the same 25 per cent reduction. Or the small local shop may industry. Forward vertical integration involves also be a food store, open until 10 o’clock at night a supplier merging with one of its buyers, such as seven days a week, again offering a service which a car manufacturer buying a car dealership, or a is not offered anywhere else in the area. A small confectionary manufacturer buying candy/sweet shop could be the only place locally where credit shops. Backward vertical integration involves a is offered, or where it is possible to buy a single purchaser buying one of its suppliers, such as a item instead of a pack of six. Equally in the case of drinks manufacturer buying a bottling manufacturer, some products, such as cricket balls, the size of the or a car manufacturer buying a tyre company. market is so small that one or two very small firms  integration is the merging of two can satisfy total demand. firms with no common interest. A tea company buying an company, or a food company REASONING, ANALYSIS buying a clothing chain would be conglomerate ACTIVITY 1 SKILLS mergers. CASE STUDY: SIZE OF BUSINESS 1 Why can small firms survive successfully in the ADVANTAGES AND DISADVANTAGES OF hotel industry? EACH TYPE OF MERGER/TAKEOVER 2 What advantages do large hotel chains enjoy over small independent hotels? There are advantages and disadvantages to firms growing organicallyCOPY or through different types of integration. Initially, almost all growth of firms is organic. This is because almost all firms start small. Vertical, HOW BUSINESSES GROW horizontal and conglomerate integration through Firms may grow in size in two ways: mergers and takeovers is associated with medium-  by organic growth sized and large firms. Merging with or taking over  by external growth through merger or takeover. another firm is expensive and time-consuming. Organic growth simply refers to firms increasing Mergers and takeovers are high risk and evidence their output, for instance through increased investment suggests that most fail in the sense that they reduce or an increased labour force. A merger is the joining the long-term share price of the company. For together of two or more firms under common mergers and takeovers to succeed there should be ownership. The boards of directors of the two some sort of strategy for the growth of the firm. companies, with the agreement of shareholders, agree Taking on an extra worker, renting the shop next door to merge their two companies together. A takeover to expand premises or buying an extra machine are implies that one company wishes to buy another much easier than targeting another firm for expansion. company. The takeover may be amicable. Company Even with medium-sized and large firms, organic X makes a bid for company Y. The growth is the norm and integration through mergers considers the bid and finds that the price offered is and takeovers is the exception. a good price for the shareholders of the company. It However, sometimes another firm has a market then recommends the shareholders to accept the offer or an asset that it would be difficult or impossible to terms. However,SAMPLE the takeover may be contested. In a gain through organic growth. For example, a European hostile takeover, the board of directors of company company may wish to expand into the Asian market Y recommends its shareholders to reject the terms but has no expertise in this market. It might be of the bid. A takeover battle is then likely to happen. cheaper and far less risky to buy a company selling Company X needs to get the shareholders to agree to into the Asian market rather than try to achieve this sell just over 50 per cent of the shares to take control. through organic growth. Organic growth may also Economists distinguish between three types of be too slow for directors and managers who wish to merger: maximise their salaries and bonuses from the business.

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The easiest way to expand rapidly and justify higher example would be a hairdresser buying a second pay is through mergers and takeovers. hairdressing business. At an international level, it might be one pharmaceuticals company buying another VERTICAL INTEGRATION pharmaceuticals company. There are several possible advantages of vertical Horizontal integration has a number of advantages integration: for the firm:  There may be cost savings. Integrating a supplier  It may allow reductions in average costs due to or a buyer into the firm may make the firm more economies of scale. efficient.  It can reduce competition in the market by removing  Vertical integration may reduce risk. For example, a a competitor. supplier might have a technology that it could offer  The firm has an increased ability to control prices in to rival firms, giving them a competitive advantage. the market. A supplier might unexpectedly refuse to sell its  It can allow one firm to buy unique assets owned by product to the firm. Alternatively, a buyer could another company, such as a new drug or operations decide to buy from another firm. in another part of the world.  Forward vertical integration could give a firm more  It allows a business to grow in a market where it control over its market. For example, if a firm owned already has knowledge and expertise. This is likely another firm that bought its products, it could to make the merger more successful. decide at what price to sell the product and in what Despite the many advantages of horizontal markets. It could better control branding of the integration, evidence suggests that most horizontal product. mergers are not successful. As with vertical There are a number of disadvantages to vertical integration, firms often pay too much for the firm they integration: are buying. Integration of the two firms is too often  A firm making a vertical merger may have little badly managed and many of the key workers may expertise in that particular industry. For example, leave following the takeover. a motor manufacturing company might, over many COPY years, have developed a deep knowledge of motor CONGLOMERATE INTEGRATION manufacturing. However, it is unlikely to have that same level of knowledge in selling cars. If the There are several advantages of conglomerate motor manufacturing company buys a chain of integration: car dealerships, to sell its cars to the public, it is  One advantage is to reduce risk. Buying another firm likely that the car dealership part of the business operating in a completely different market means will perform much worse than the core motor that a firm is not so dependent on the ups and manufacturing business. The more distinct parts downs of one market. there are to a business, the less likely it is that  A conglomerate may find it easier to expand senior will be able to get the best out compared to a situation where the companies of every part of the business. or operations are independent. Size gives a  Firms often pay too much for the firm they take conglomerate more options to obtain finance to over and the share price of the firm falls rather expand the business. Successful senior managers than rises. can be transferred from company to company  There can be difficulties in merging two firms depending on their need. together into one firm. Either the costs of creating a  It could be an opportunity for asset stripping. single firm from two separate firms are too great, or Some companies specialise in buying other the two firms fail to integrate but costs rise because companies which they see as having more valuable extra layers of management are needed to control individual assets than the purchase price of the the new, larger firm. company. For example, a company might be bought  Many of theSAMPLE key workers in the firm that has been for $100 million. It is then broken up. Most of its taken over may leave, taking with them much of the land holding might be sold for $60 million, a part expertise that made it successful. of the company is sold for $30 million and some patents are sold for $20 million. What is then left of the company might be kept, sold on or simply HORIZONTAL INTEGRATION closed down. Most mergers and takeovers are examples of One disadvantage of conglomerate integration is horizontal integration. At the small firm level, an that firms do not have expertise in the market into

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REASONING ACTIVITY 2 SKILLS CASE STUDY: GROWTH BY TAKEOVERS Robert Forrester is chief executive of the fast- growing UK motor dealer, Vertu. He learned about the business of selling cars by being a group finance director for Reg Vardy, the Sunderland based motor dealer. In 2006, Reg Vardy was taken over by Pendragon and Mr Forrester lost his job. He decided to set up his own car dealer company. He realised that he could not challenge the big, long-established companies in the sector by setting up just another small, privately owned dealership. Instead, his strategy was to grow through buying up existing businesses. He assembled a team of former Reg Vardy executives and persuaded City of London investors to invest £25 million in a new, publicly quoted company. Mr Forrester himself Car dealerships fell in price and Vertu accelerated invested £400,000. Vertu Motors floated on AIM (the its acquisition-buying programme. In 2009, it raised Alternative Investment Market based in London) in a further £300 million by selling new shares to fund December 2006. more purchases. Its first deal was the £40 million takeover of Today, Vertu has over 5000 employees and Bristol Street Motors Group, which had sales of £576 128 car dealerships across England and Scotland. million. The purchase was funded through the initial Sales were £2.8 billion in 2018 with pre-tax profit £25 million raised a year earlier and a further £26 approaching £25COPY million. million sale of shares. 1 What is meant by horizontal integration? Use Vertu When the recession struck in early 2008, car as an example. values dropped 5 per cent in a month. With £20 2 Give two constraints on business growth that Vertu million worth of stock, the company suffered an might have experienced. overnight loss of £1 million on the value of the cars it 3 Would Vertu have been more successful if it had held. However, the company survived. The recession grown organically rather than through takeovers? also provided a good buying opportunity for Vertu. Give reasons for your answer.

which they buy. As with vertical integration, a lack of CONSTRAINTS ON BUSINESS GROWTH specialist understanding of the market can reduce There are a number of different constraints on performance. As for asset stripping, it provides a quick business growth, including the following. profit for the asset stripper. It doesn’t benefit workers, customers or local economies. Workers lose their jobs. Customers might find they are no longer able to buy SIZE OF THE MARKET products which they value. Local economies can end Markets vary in size. Some local markets are very up with fewer jobs and disused industrial sites. As with small. Take the example of a flower shop in a large vertical integration, firms engaging in conglomerate village in rural . The local market may be able integration oftenSAMPLE pay too much for the firm they are to support the business adequately with customers buying. Integration of the two firms is too often poorly coming from surrounding villages. However, expanding managed and many of the key workers may leave the business, for example by opening a new shop in following the takeover. Moreover, resources of the the next village, may fail because there are not enough business and the time and effort of senior managers customers in the market in the two villages. Equally, may be spread too thinly over the range of activities national and international markets can be relatively the business is involved in. small. The market for cricket balls, for example, is much

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smaller than the market for coffee. The opportunities it. About 300 mergers are typically notified to the for expansion in the cricket ball market are very limited Commission each year in the EU. in comparison to the coffee market.

ACCESS TO FINANCE REASONS SOME FIRMS TEND TO REMAIN To expand, firms need access to finance. Most SMALL AND OTHERS GROW firms expand by using the profit they have made It is suggested that profit maximising companies are in previous years and putting this back into the motivated to grow in size for a number of reasons. business. However, firms also commonly use loans  A larger company may be able to exploit economies and overdrafts from banks to finance their expansion. of scale more fully. The merger of two medium- This depends on banks being willing to give them a sized car manufacturers, for instance, is likely to loan. For medium-sized and large firms, they may be result in potential economies of scale in all fields, able to obtain funding. In a limited company, from production to marketing to finance. Vertical new shares are sold to investors. If the company and conglomerate mergers are less likely to yield is a public limited company, second-hand shares economies of scale because there are unlikely to will be bought on a stock exchange, like Abu Dhabi be any technical economies. There may be some Securities Exchange (ADX) that lists mostly UAE marketing economies and more likely there may be companies and NASDAQ Dubai that lists international some financial economies. companies. However, companies only gain the finance  A larger company may be more able to control its from a share issue when it is the new issue of these markets. It may therefore reduce competition in the shares; the rest of the time shares are traded the market place in order to be better able to exploit the finance does not go to the company, it simply allows market as its price-setting power is increased. shares to change ownership. However, being able  A larger company may be able to reduce risk. to sell shares does make it easier to raise the initial Many conglomerate companies have grown for finance from investors. this reason.COPY Some markets are unreliable. They are subject to large changes in demand when OWNER OBJECTIVES economies go into boom or recession. A steel manufacturer, for instance, will do exceptionally Not every owner wants to grow a firm. Owners can well in a boom, but will be hard hit in a recession, have many objectives. They may be happy with the so it might decide to diversify by buying a profit they are currently making and not wish to have company with a product which does not have a the extra work or the extra risk that comes from demand pattern that changes in different parts of growing the business. the economic cycle, such as a supermarket chain. Other industries face a very uncertain future, such REGULATION as the newspaper industry (which faces falling Most firms are able to expand their businesses revenues due to the rise of digital media) so without any interference from government. However, newspaper companies may merge or be taken over government regulation can be an important factor by other companies to reduce the risk of failure. in a few cases. For example, EU Merger Regulation  Where there is a divorce of ownership from control, prohibits mergers and takeovers which would a larger company may justify higher salaries and significantly reduce competition in the EU Single bonuses to directors and managers. Since it is Market, for example if they would create dominant directors and managers who run the firm, they companies that are likely to raise prices for consumers. can take decisions about the size that will benefit The EU authorities only examine larger mergers with them, but not necessarily bring any benefit to an EU dimension, meaning that the merging firms shareholders. reach certain SAMPLEturnover levels. For large companies, While some firms grow large others remain small. This competition law can restrict the scope for takeovers is due to many reasons, such as: and mergers. Any merger which creates a company  The owners want the business to remain small with a combined worldwide turnover of all the merging and do not want to have the increased risk from firms over €5000 million and an EU-wide turnover operating a larger firm or take unnecessary risks for each of at least two of the firms over €250 with personal finance. million would be reported to the Commission. It can  The firm may operate in a niche market and so investigate the merger and has the power to forbid demand may be too low to expand.

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 The firm may offer a personal service, where loyal are having to divide their time between two or more customers know the owners. Such customers may businesses which have little to do with each other. go elsewhere if the business grows.  The owners may lack the expertise and finance to VALUE expand and are happy to remain small. The price of the demerged firms might be higher than the price of the single larger firm. For example, a firm IMPACT OF GROWTH OF FIRMS may be valued at $300 million on a stock exchange. ON BUSINESSES, WORKERS AND But if it split into two, the new firms might be valued at $150 million and $250 million. Investors in companies CONSUMERS base valuations on a variety of different factors but Businesses will benefit from a merger if economies of one of them is the growth prospects of a firm. If a scale lead to greater efficiency. If firms are able to cut firm has a part which is growing fast, that part will be costs or develop new and innovative products, their worth more than another part of equal size which is profits should rise. Greater efficiency will also enable growing more slowly. The relatively poor performance firms to survive greater competition in their markets. of one part of a company can drag down the share However, if the merger leads to diseconomies of scale price of the whole company despite the fact that other and inefficiency then profits are likely to fall. parts are performing well. Financial markets talk about Workers may benefit or lose out following a ‘creating value’ by splitting up companies in this way. merger. Some workers may gain promotion in the new, larger firm while others might lose their jobs. FOCUSED COMPANIES For example, if only one senior financial director is In the 1970s, it was fashionable to create required in the new firm, the financial director from conglomerates to diversify risk. In recent years, the first firm may be promoted while the financial it has become popular to create firms which are director from the firm that has been taken over is made highly focused on one or just a few key markets. The redundant or moved to another job. If the new, larger argument is that management can deliver higher profits business is more successful then higher wages may COPY and growth by concentrating their energies on getting be paid. to know and exploiting a limited range of markets. Consumers may benefit or lose out following a Evidence also suggests that being the market leader merger. They will gain if the merged firms become in terms of sales tends to be relatively more profitable more efficient, cut costs and offer lower prices. They than being, say, number three or four in the market. could also gain if the merged firms invest more and Companies therefore divest themselves of (i.e. sell develop new and innovative products. Consumers off) parts which do not fit in with their core activities. will lose out if the merger reduces the number of Sometimes, a firm will sell off a part cheaply which firms in the market and there is less choice. If market goes on to be very successful. It could be argued share increases for the newly formed company, there that the firm’s management sold the part too cheaply. is the possibility of prices increasing if there is less Equally, this can be seen as evidence that a company competition. has only limited management resources. The part sold off would never have been successful within that REASONS FOR DEMERGERS particular firm because management did not have the A demerger occurs when a firm splits itself into time or expertise to make it succeed. two or more separate parts to create two or more firms. The new firms may be of roughly equal size. IMPACT OF DEMERGERS Sometimes, though, the term is used to describe the Demergers can have an impact on businesses, workers sale of a small part of a business to another business. and consumers. Demergers occur for a variety of reasons: Businesses will benefit from a demerger if the increased specialisation that results leads to greater LACK OF SYNERGIESSAMPLE efficiency. If firms are able to cut costs or develop Management may feel that there are no synergies new and innovative products, their profits should rise. between the parts of the firm. This means that one Greater efficiency will also enable firms to survive part of the firm is having no impact on the more greater competition in their markets. Firms will lose efficient and profitable running of the other part of the out if the demerger leads to more inefficiency. If the firm. Where there are no synergies, there could even demerged firms are run less well than when they were be diseconomies of scale because senior management one single firm, then profits are likely to fall.

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Workers may benefit or lose out following a Consumers may benefit or lose out following a demerger. Senior managers may gain promotion. For demerger. They will gain if the demerged firms become example, one firm only needs one senior financial more efficient, cut costs and offer lower prices. They director. If it splits into two, each firm will need its could also gain if the demerged firms invest more and own senior financial director. On the other hand, some develop new and innovative products. Consumers will workers may lose their jobs following a demerger. If lose out if the demerged firms become more focused each firm becomes more efficiently run as a result of on increasing profit in their businesses through raising the demerger, then some job losses are likely. prices or reducing their product ranges.

REASONING ACTIVITY 3 SKILLS CASE STUDY: DEMERGER eBay Inc is to be split into two companies. It owns as two separate companies. This is because the two eBay, the online auction site and PayPal, a payments businesses have different growth rates and profit business. rates. PayPal is the star performer, with revenues up For some time, the company has come under 20 per cent. eBay is highly profitable but it is forecast pressure from some shareholders to sell PayPal. They to grow only between zero and 5 per cent in the next argue that eBay and PayPal would be worth more few years. Some analysts have questioned whether eBay, the auction site, will be as profitable without PayPal. Currently, eBay uses information about customer purchases made from other internet sites when these purchases are made using PayPal. Without PayPal, it will have less COPYinformation about the buying behaviour of its customers. This will make it more difficult to target eBay users with information about what they could buy on the site. 1 Why might eBay demerge with PayPal? 2 To what extent is the demerger likely to lead to higher growth for each of the businesses?

THINKING LIKE AN ECONOMIST MCDONALD’S STEPS UP EXPANSION IN ASIA AND McDonald’s has mainly expanded by organic growth. It was originally founded in America by the McDonald brothers in 1940. It grew by using a franchise model to expand organically across America. In the first few decades it established itself across America but from the 1970s onwards it began to open restaurants in several other countries. The American market had become saturated (where so much of a product is offered for saleSAMPLE that there is more than people want to buy) and if McDonald’s wanted to continue to expand it needed to move into other markets. It now has restaurants across most countries in the world and has kept its own brand identity, not growing by taking over other companies.

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An example of its growth is its plans to open more the two countries, 54 per cent more than the 2800 it than 1500 restaurants in China and South Korea with had in 2017. local partners between 2017 and 2022, as it focuses McDonald’s is also opening 20 new restaurants on expansion in the world’s second-biggest economy. in Russia, as it aims to expand its business in this There are many difficulties in expanding into a market market as well. It has signed an agreement with such as China. However, local partners will help local company GiD, which will extend McDonald’s make business decisions that are suitable for Chinese restaurants into western Siberia. It is hoped that the customer tastes while increasing funds available for agreement with GiD will help enhance the McDonald’s investment needed. Once the outlets are opened, brand in Russia, build a successful business over the McDonald’s, the world’s largest fast-food chain by long term and further strengthen the relationship with sales, will have more than 4300 restaurants across its customers.

CHECKPOINT

1 What is the difference between SMEs and 7 Give the advantages and disadvantages of large ? horizontal integration. 2 What is the difference between organic growth 8 Give the advantages and disadvantages of and growth by merger or takeover? conglomerate integration. 3 What is the difference between forward 9 Why do some firms remain small while others vertical integration and backward vertical grow? integration? 10 How does the growth of firms affect 4 What is meant by horizontal integration? businesses,COPY workers and consumers? 5 What is meant by conglomerate integration? 11 What are the reasons for demergers? 6 Give the advantages and disadvantages of 12 What is the impact of demergers on vertical integration. businesses, workers and consumers?

SUBJECT VOCABULARY asset stripping the practice of buying a company cheaply and merger or takeover the joining together of two or more firms then selling all the things it owns to make a quick profit under common ownership backward vertical integration a joining together of two or niche market a market for a product or service, perhaps an more firms into one firm, where the purchaser merges with expensive or unusual one, that does not have many buyers one or more of its suppliers but that may make good profits for companies that sell it conglomerate integration a joining together into one firm of organic growth a firm increasing its size through investment two or more firms producing unrelated products in capital equipment or an increased labour force demerger when a firm splits into two or more independent synergy/synergies when two or more activities or firms put businesses together can lead to greater outcomes than the sum of the forward vertical integration a joining together of two or more individual parts firms into one firm, where the supplier merges with one or vertical integration a joining together into one firm of two more of its buyers. or more firms at different production stages in the same horizontal integrationSAMPLE a joining together of two or more firms industry in the same industry at the same stage of production

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REASONING, ANALYSIS, CRITICAL THINKING CELGENE SKILLS

Pharmaceutical companies spend billions of pounds George Golumbeski, senior vice-president of researching and developing new drugs. The problem at Celgene, says the company is that very few of those drugs ever make it to market. has been pursuing what it calls a ‘distributive model of Either they do not work well enough or they have research and development’. ‘We consciously decided significant side effects. not to always grow our own R&D and that we would Large pharmaceutical companies may then be work as closely and actively as we could with smaller forced over the ‘patent cliff’ (when there is a huge companies, who have an exquisite focus, a leanness fall in its revenue after the patent runs out). Many and a superior, efficient output.’ pharmaceutical companies rely on just one or a few It is unlikely that all of Celgene’s takeovers will be ‘blockbuster’ drugs for most of their sales. Celgene, for successful, given that so many of the companies are example, a biotech company with a market value of focused on drugs that are still at an early stage of almost $100 billion, is heavily reliant on sales of one development. However, it only needs one or two to drug, Revlimid. The drug accounts for 65 per cent of deliver a ‘blockbuster’ drug to prevent its sales from annual sales of the company. In 2019, it faces its own falling once Revlimid begins to go out of patent after patent cliff when patents on Revlimid begin to expire. 2019. This means that any pharmaceutical company will be able to produce its own ‘generic’ copy of Revlimid and sell it to customers, usually for a fraction of the price of the original drug. Celgene could then see its sales fall dramatically in value and billions could be knocked 1 Using pharmaceutical companies as an example, off its share value. explain what it means for a firm to grow Celgene has responded to this threat by buying internally. (4 marks) up companies completely or in part, or entering 2 Analyse one advantage and one disadvantage to into agreements with companies to share the costs consumers of horizontal integration. (6 marks) and revenues of promising new drugs. For example, Celgene has spent $7.2 billion buying Receptos, a 3 Analyse two possible reasons why Celgene has biotech company specialising in treatments for multiple chosen to grow through a process of horizontal sclerosis and inflammatory bowel conditions. In April, integration rather than to grow organically. it paid $710 million to Nogra Pharma, a privately (6 marks) held Irish biotech company, to access its drug for 4 Evaluate whether it would be better for Crohn’s disease, a bowel disorder. The drug is still at pharmaceutical companies, such as Celgene, to the clinical trial stage and Celgene is hoping that it become conglomerates rather than remaining will make it to market. In 2018, Celgene bid to take narrowly focused on selling pharmaceutical over Juno and enter the new field of chimeric antigen products. (20 marks) receptor therapy (Car-T), which involves re-engineering a patient’s white blood cells so they can identify and attack cancer. Celgene also announced it would pay EXAM HINT $1.1 billion for Impact Biomedicines, another cancer company, in a transaction that could be worth up to $7 Evaluation for Question 4 will come from comparing billion if the group’s medicine is successful. the advantages and disadvantages of conglomerates In all, overSAMPLE the past six and a half years, Celgene using pharmaceutical COPY companies as an example. has taken minority stakes or struck agreements with Evaluation could also come from a discussion of the more than 30 companies, as well as taking over two meaning of ‘better’. What are the possible objectives companies completely: Receptos for $7.2 billion and of pharmaceutical companies and how might this Abraxis for $2.9 billion. affect their decisions?

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