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Normal and Abnormal Profit Unit 4 Industrial Economies Steve Margetts CONTENTS The birth and growth of firms. The 2 motives and methods of growth Costs 4 Revenue. 7 Profit. 9 Alternative motives for firms 14 Short run and long run. 16 Diminishing Marginal Returns and 17 Economies of scale. Perfect competition 20 Monopoly 25 Monopolistic competition 28 Oligopoly 32 Cartels 34 Productive and allocative efficiency 37 Monopoly And The Public Interest 42 Measures of market concentration 45 Price discrimination in monopoly 46 Pricing and non-pricing strategies 50 Contestable markets 51 Competition policy 54 Regulation of privatised industries 56 Index 61 www.revisionguru.co.uk Page 1 Unit 4 Industrial Economies Steve Margetts THE GROWTH OF FIRMS Firms can grow in one of two ways: • Internal growth. • External growth. INTERNAL GROWTH This requires an increase in sales. In order to do this the firm will have to promote existing products and launch new products, this will require an increase in productive capacity. It can finance growth via borrowing, retaining profits (internal funds) or issuing new shares. EXTERNAL GROWTH Mergers and takeovers are ways in which businesses can grow externally and grow by joining together to form one company. Mergers are mutual agreements between the companies involved to join together. Most takeovers tend to be hostile, in that the company being taken over does not want to be bought by the larger business. Takeovers do not need to be and are not always hostile, as some in fact can be friendly, in that the company being taken over wants to be taken over and can even ask to be taken over. WHY DO COMPANIES JOIN TOGETHER? • It is the quickest and easiest way to expand. • Buying a smaller competitor is normally cheaper than growing internally. • Simple survival – survival of the fittest. To continue in the market the company may need to grow and the easiest way is to buy up someone else. • The main aim of the business may be expansion. • Investment purposes. Buying up other businesses is a form of investment. • To prepare for the European Single Market. • To asset strip. Some companies buy other companies in order to sell off the most profitable assets of the business and make a profit. • To gain economies of scale. TYPES OF MERGER/TAKEOVER • Horizontal: A horizontal merger/takeover is one where two businesses in exactly the same line of business or stage of production join/merge with on another, for example if two hairdressers joined together. • Forward Vertical: A forward vertical merger/takeover is where a business merges with a business at the next stage of the production process, for example a business making furniture may merge with the retail outlet selling the furniture. • Backward Vertical: A backward vertical merger/takeover is where a business merges with a business at the previous stage of the www.revisionguru.co.uk Page 2 Unit 4 Industrial Economies Steve Margetts production process, for example the business making the furniture may merge with the business that supplies the wood and parts for the furniture. • Lateral: A lateral merger/takeover is where a business merges with a business who makes similar goods to it but who are not in competition with each other, for example if a chocolate bar manufacturer merged with a luxury chocolate manufacturer. • Conglomerate/Diversification: A conglomerate/diversification merger or takeover is where businesses in completely different industries merge together, for example if a football club merged with a computer firm. JOINT VENTURES Some businesses join forces with other businesses to share the cost of a project because it is too expensive for one business, share expertise of staff and machinery etc. This is known as a joint venture. The benefits of joint ventures are: • Businesses have all the advantages of merges but no lose of company identity. • Each business can specalise in its field of expertise. • Expensive costs of mergers/takeovers are not incurred. • Mergers/takeovers can be unfriendly and do not work – staff are concerned about job losses. • Competition may be reduced due to joint venture. Drawbacks of joint ventures: • Anticipated benefits of the venture may not appear due to difficulties of running ‘one’ business for the venture. • Disagreements about who is in charge can result. • As profits are normally split this could cause problems if one business feels it has put more effort, time, money than the other. Mergers were very common during the late 1980’s with many companies merging with competitors and other businesses. Whereas towards the end of the 1990’s most companies have decided that large companies with numerous businesses is in fact bad and leading to un-competiteveness (due to dis-economies of scale), this has lead to a trend of firms de-merging. www.revisionguru.co.uk Page 3 Unit 4 Industrial Economies Steve Margetts Acquisitions and mergers by UK industrial and commercial companies: 1970-98 1600 35 1400 Number 30 d e r i Expenditure u 1200 E q x c 25 p a e n s e 1000 d i i t n 20 u a r p e 800 m ( £ o b c 15 n ) of 600 er b 10 m 400 u N 200 5 0 0 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 Source: Financial Statistics (ONS) More and more mergers took place across borders within the EU, as shown in the table below. Cross-boborrder majoritjority mergers and acqacquuisitionisitionss targeting an EU company 180 2500 160 Over $1bn Under $1bn 2000 ) 140 s e Number ic s r 120 l a p 8 1500 de 9 9 100 of 1 r t e a b ( 80 s 1000 m n u 60 N illio b $ 40 500 20 0 0 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Source: Based on information provided by Thomson Financial Securities Data COSTS Economists work out costs slightly differently from how an accountant would. Economists use the concept of opportunity cost to work out the costs of a firm. First we work out the cost of the factors of production used (these are the www.revisionguru.co.uk Page 4 Unit 4 Industrial Economies Steve Margetts costs an accountant would use) and then we add the opportunity cost of using them. The following are all examples of opportunity costs that could be added to the accounting cost to arrive at the economic cost: • The owner could work for somebody else's company and earn £20,000. This £20,000 is the opportunity cost of the owner's labour. • The shop that the hairdresser owns could be rented out for £500 per week. This £500 per week is the opportunity cost of using the shop. • The owner draws £10,000 from the bank to refurbish the shop. The opportunity cost of this £10,000 is the interest that it would have received if it were left in the bank. We can identify two types of cost, fixed and variable. Fixed costs don't vary with the level of production. As production rises or even falls to zero the fixed costs remain the same and have to be paid, e.g., rent on buildings and machinery, utility charges, staff with contracts and advertising campaigns that are underway. Variable costs on the other hand vary directly with the level of output. As production increases so does the variable cost, e.g., raw materials and casual labour. Total Fixed Costs (TFC) are drawn as a straight line, this indicates that they don't change whatever the level of output. Total Costs (TC) and Total Variable Costs (TVC) both rise parallel to each other. The distance between the TC and TVC is equal to the TFC, this must be so as TC=TFC+TVC. s t s Co Total Costs Total Variable Costs Total Fixed Costs O Output www.revisionguru.co.uk Page 5 Unit 4 Industrial Economies Steve Margetts Average cost curves (AC, AFC and AVC) are simply the relevant cost divided by the quantity of output (we will look at the shape of these curves in the next section). The Marginal Cost (MC) is the extra cost of increasing output by one unit, e.g., if it costs £50 to produce 10 units and £55 to produce 11, the marginal cost of the 11th unit is £5 and it is plotted halfway between 10 and 11 units. It is possible to represent these costs on a diagram by drawing total, average and marginal cost curves. It is important to note that the MC always intersects the AC at its minimum. MC AC AVC ) £ sts ( o C AFC Output (Q) Remember from unit 1, we are able to distinguish between short run and long run average costs. www.revisionguru.co.uk Page 6 Unit 4 Industrial Economies Steve Margetts s t s Co SRAC1 SRAC5 SRAC2 SRAC4 SRAC3 LRAC Economies of Scale Diseconomies of Scale O MES Output REVENUE We identify the Total (TR), Average (AR) and Marginal (MR) Revenues. Total revenue equal to all of the money received for the sale of goods or services. It equals the quantity sold multiplied by the price. Average revenue is the average amount received per item sold. If all output is sold at the same price then the average revenue must equal the price. Marginal revenue is the amount received from selling an extra unit of output, i.e., how much has the total revenue changed by. The diagrams below show the revenue curves where the demand curve is downward sloping. www.revisionguru.co.uk Page 7 Unit 4 Industrial Economies Steve Margetts nue e v Re TR Quantity nue e v Re MR AR Quantity The diagrams on the below show the revenue curves where the demand curve is perfectly elastic.
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