edexcel a level economics year 2: microeconomics … a level economics year 2: microeconomics topics...

EdexcelALevelEconomics

Year2:MicroeconomicsTopics

CourseCompanion

Edition:September2016

www.tutor2u.net

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Sizesandtypesoffirms......................................................................................................................4SmallBusinesses.............................................................................................................................4DivorcebetweenOwnershipandControl&thePrincipalAgentProblem....................................5PublicandPrivateSectorOrganisations........................................................................................8ProfitandNot-for-ProfitOrganisations..........................................................................................9

BusinessGrowth...............................................................................................................................11Howbusinessesgrow...................................................................................................................11BusinessGrowthfromIntegration...............................................................................................13KeyConstraintsonBusinessGrowth............................................................................................16

Demergers........................................................................................................................................18BusinessObjectives..........................................................................................................................19ProfitMaximisation......................................................................................................................20RevenueMaximisation.................................................................................................................20SalesMaximisation.......................................................................................................................21ProfitSatisficing............................................................................................................................22

Costs,revenuesandprofits..............................................................................................................24Productionintheshortrun..........................................................................................................24Costs.............................................................................................................................................25Costsofproductionintheshortrun............................................................................................25EconomiesandDiseconomiesofScale........................................................................................32Longrunaveragecost(LRAC).......................................................................................................32Revenues......................................................................................................................................39Normalprofits,supernormalprofitsandlosses...........................................................................44Profitmaximisationintheshortrun............................................................................................46

EconomicEfficiency..........................................................................................................................48IntroductiontoMarketStructures...................................................................................................50PerfectCompetition.........................................................................................................................53AssumptionsoftheModel...........................................................................................................53Profitmaximisationintheshortrun............................................................................................55Profitmaximisationinthelongrun..............................................................................................55Shutdownpriceandbreak-evenprice........................................................................................57PerfectCompetitionandEfficiency..............................................................................................58

MonopolisticCompetition...............................................................................................................59Assumptionsofthemodel...........................................................................................................59Revenuecurvesinmonopolisticcompetition..............................................................................60Profitmaximisationintheshortrun............................................................................................60Profitmaximisationinthelongrun..............................................................................................60Non-pricecompetition.................................................................................................................61Monopolisticcompetitionandeconomicefficiency....................................................................62

Oligopoly..........................................................................................................................................63Assumptionsofthemodel...........................................................................................................63MeasuringMarketConcentration–TheN-FirmConcentrationRatio.........................................64Non-collusiveoligopoly................................................................................................................65GameTheory................................................................................................................................69ThePrisoners’Dilemma...............................................................................................................70PotentialBenefitsfromCollusion–AGameTheoryExample.....................................................72FirstMoverAdvantageinMarkets...............................................................................................72Open/FormalCollusioninanOligopoly......................................................................................74CollusionandEfficiency................................................................................................................77

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Tacit/informalcollusion...............................................................................................................77Monopoly.........................................................................................................................................78NatureofMonopolyPowerinMarkets.......................................................................................78MonopolyandProfitMaximisation.............................................................................................79RevenueMaximisation.................................................................................................................80NaturalMonopoly........................................................................................................................81MonopolyandEfficiency..............................................................................................................83PoliciestoRegulateMonopolyPower.........................................................................................85

PriceDiscrimination.........................................................................................................................86Necessaryconditionsforpricediscrimination.............................................................................86MainAimsofPriceDiscrimination...............................................................................................86TypesofPriceDiscrimination/DynamicPricing..........................................................................87PriceDiscriminationandEfficiency/Welfare..............................................................................90

Monopsony......................................................................................................................................91Contestability...................................................................................................................................92PricesandProfitsinaContestableMarket..................................................................................95

LabourMarket..................................................................................................................................97DemandforLabour......................................................................................................................97LabourSupply.............................................................................................................................100LabourImmobility......................................................................................................................104Wagedeterminationincompetitivelabourmarkets.................................................................105Wagesandemploymentinimperfectlycompetitivelabourmarkets........................................107MonopsonyintheLabourMarket.............................................................................................107DiscriminationintheLabourMarket.........................................................................................109TradeUnionsintheLabourMarket...........................................................................................111LabourMarketFailure&GovernmentIntervention..................................................................115MinimumWagesintheLabourMarkets....................................................................................116KeyLabourMarketIssuesandDatafortheUK..........................................................................119

GovernmentIntervention..............................................................................................................126Governmentinterventiontocontrolmergers...........................................................................127Governmentinterventiontocontrolmonopolies......................................................................128Interventiontopromotecompetitionandcontestability..........................................................131Governmentinterventiontoprotectsuppliersandemployees.................................................135Impactofgovernmentintervention...........................................................................................137

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SizesandtypesoffirmsSmallBusinessesThebulkofbusinessesregisteredintheUKeconomyaresmall.Whydomanysmallfirmssurvive?Themedianprofitofsmall&mediumsizedenterprisesintheUKin2014was£8,000.Yetmanysmallbusinessescontinuetosurviveandgrow:

1. Manysmallerbusinessesactasasupplier/sub-contractortomuchlargerenterprisesespeciallyintheconstructionindustry

2. Theymighttakeadvantageofalowpriceelasticityofdemandandhighincome-elasticityforspecialist‘niche’productswhichcanbesoldatahigherpricewithalargeprofitmargin

3. Smallerbusinessescanavoiddiseconomiesofscale(risingaveragecost)4. Manysmallerbusinessesrunaslifestyleenterprises,suggestingthattheirownersare

lookingtoachieveasatisfactoryreturnratherthanmaximumprofits5. Small-scalebusinessesareoftenmoreinnovative,flexibleandnimbleinrespondingto

changesinmarketdemandconditions6. Smallbusinesseshavebenefittedfromtherisingpercentageofconsumerswillingtobuy

online–thebarrierstoentryintothemarkethavecomedownbecauseofdigitaltechnology(e.g.techstart-ups)

SmallerFirms&BusinessObjectivesManysmallerfirmshavedifferentbusinessobjectivestolarger,scaledcorporations:

TypicalObjective RelevancetoSmallerFirms

BusinessSurvival Akeyobjectiveforstart-upfirmsandmanysmallerfirms.Whilstsmallfirmshavelowercosts,over-relianceononeorafewproductscanthreatensurvival.

RevenueMaximisation

Rarelyakeyobjectiveforsmallerfirms,althoughtheyareoftenkeentogrowsalesalbeitfromalowbaselevel.

ProfitMaximisation Smallerfirmswillnormallyearnlowerabsolutelevelsofprofit(becausetheirrevenuesarelower).However,theycanstillachievehighprofitmarginsifoperatinginasuitablenichemarket.

CostEfficiency&Scale Smallerfirmsareunlikelytobenefitfromeconomiesofscalealthoughtheymaybegoodatkeepingtheircostbaselow.

CustomerService Smallerfirmsareoftenassociatedwithhigherlevelsofcustomerserviceandsatisfaction,oftenbecausethebusinessowneriscloselyinvolvedwiththeprovisionofcustomerservice.

SomeKeyReasonstoStaySmall

• Productdifferentiation&USP(uniquesellingpoint)o Positioningabusinessas“small”canhelpdifferentiateagainstlargercompetitorso Customerperceptionmaybeanexpectationofabetterproductfromabusiness

that“cares”

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o Morescopeforaddingvaluethroughsellingspecialistexpertise(e.g.advice)• Flexibilityinmeetingcustomerneeds

o Manysmallbusinessestalktotheircustomersregularly;sometimeeverydayo Smallfirmsoftencommunicateinthecustomers’languagewhichgivethe

impressiontothecustomerthattheyaremoreintunewiththeirneedso Makesiteasiertogetcustomerfeedback(largerfirmsoftenstrugglewiththis)

• Deliverhighstandardofcustomerserviceo Mostsmallbusinessesoperateinthe“service”sector,sothisisakeysourceof

competitiveadvantageo Employeesinsmallerfirmsarelikelytotreatcustomerserviceasapriority

(comparedwithlargerfirms)thoughthereisnoguarantee!• Exploitopportunitiesfrome-commerce

o E-commerceisanobvious(andincreasinglycommon)wayforsmallfirmstoreachabroadercustomerbase

o Itisnowrelativelyeasyforasmallfirmtotargetnichesegmentsbothdomesticallyandoverseasusinge-commerce

o Smallerfirms,providedtheyareconfidentwithitsuse,cangainsignificanttractionwithcustomersusingsocialmedia

• Avoidrisksfromdiseconomiesofscale• Smallerfirmscanbemoreinnovative/creative

DivorcebetweenOwnershipandControl&thePrincipalAgentProblemShareholdersandStakeholdersinaBusiness

• Stakeholders:o Astakeholderisanyindividualororganisationwhohasavestedinterestinthe

activitiesanddecisionmakingofabusiness• Shareholders:

o Ownthebusiness–theyhaveanequitystakeinthebusiness-perhapsafoundero Mayalsoworkinthebusinesso Mainlyinterestedingrowingthevalueoftheirshareholding

§ Capitalgain–anincreaseinthemarketvalueofashare§ Dividends–ashareoftheprofitsmadebyabusiness

WhatStakeholdersAreInterestedInStakeholder Mainlyinterestedin:Shareholders/Owners

Returnoninvestment+profitsanddividendsSuccessandgrowthofthebusinessProperrunningofthebusiness

Managers&Employees

Rewards,includingbasicpayandotherfinancialincentivesJobsecurity&workingconditionsPromotionopportunities+jobsatisfaction&status–motivation,rolesandresponsibilities

Customers ValueformoneyProductquality&customerservice

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Suppliersinthemarket

Continued,profitabletradewiththebusinessFinancialstability–canthebusinesspayitsbills?

Banks&otherfinanceproviders

Canthebusinessrepayamountsloanedorinvested?ProfitabilityandcashflowsofthebusinessGrowthinprofitsandvalueofthebusiness

Government Thecorrectcollectionandpaymentoftaxes(e.g.VAT)Helpingthebusinesstogrow–creatingjobsCompliancewithbusinesslegislation

Localcommunity Successofthebusiness–particularlycreatingandretainingjobsCompliancewithlocallawsandregulations(e.g.noise,pollution)

PotentialConflictsbetweenStakeholdersBusinessDecision Likelytobe

SupportedByPossiblyOpposedBy?

Cutjobstoreducecosts ShareholdersBanks

EmployeesLocalcommunity

Addextrashiftstoincreasefactorycapacity

ManagementCustomers&suppliers

Localcommunity

Introducenewmachinerytoreplacemanualwork

CustomersShareholders

Employees

Increasesellingpricessignificantlytoimproveprofitmargins

ShareholdersManagement

Customers

TheDivorcebetweenOwnershipandControlInmostbusinessesthereisadivorcebetweenownershipandcontrol.Inotherwords,theownersofabusinessmaynotbethesamepeopleasthosewhoaretakingkeyday-to-daydecisions.Agencyproblem Possibleconflictsofinterestthatmayresultbetween

shareholders(principal)andthemanagement(agent)ofafirm

Stakeholders Inmostbusinessestherearemanydifferentstakeholders.Theseincludecustomers,managers,employees,shareholders,debtholdersandthegovernment

Stakeholderconflict Stakeholderconflictoccurswhendifferentstakeholdershavedifferentobjectives.Firmshavetochoosebetweenmaximizingoneobjectiveandsatisfactorilymeetingseveralstakeholderobjectives,socalledsatisficing

PrincipalAgentProblemTheprincipalagentproblemisanasymmetricinformationproblem.Theownersofafirmoftencannotobservedirectlytheday-to-daydecisionsofmanagement.Decisionsandperformanceoftheagentarecostlyanddifficulttomonitor.

• Principalo Ownerofthebusiness

• Hiresanagento e.g.salesorfinancemanager

• Managerso Mayhavedifferentbusinessobjectives

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OvercomingThePrincipalAgentProblemWhatisinthebestinterestofthemanagementisnotnecessarilythesameaswhatisintheoptimuminterestsoftheshareholders.Strategiesinvolvetryingtoaligntheaimsofthesetwodifferentstakeholders.

• Employeeshareownershipschemeso JohnLewisandWaitrosehaveahighly-regardedpartnershipmodelo Stockoptionsmightleadtoperversebehaviour–e.g.deliberateattemptstohike

upsharepricesthroughillegalaction(thinkbacktothecaseofEnron)• Longtermemploymentcontractsforseniormanagement

o Securityoftenuremightencouragemanagerstotakedecisionsinthelongtermbestinterestsofthebusiness

• Longtermstockcommitmento Apple’snewpolicy(2013)requiresseniorexecutivesatAppletoholdthreetimes

theirannualbasesalaryinstock,andexecutiveshavetokeepthissalaryinstockforaminimumoffiveyearstosatisfytherequirement

Activistshareholders

• Activistshareholderslooktoputpressureonexistingmanagementorforcethroughchangestomanagementboards.

• Someinsistonbusinessesusingprofitstobuy-backsharestoincreasereturnstoexistingshareholders.

• Anactivistshareholderusesanequitystaketoputpressureonexistingmanagement.• Thegoalsofactivistshareholderscanrangefromfinancial(e.g.increaseofshareholder

valuethroughchangesindividenddecisions,plansforcostcuttingorinvestmentprojectsetc.)tonon-financial(e.g.dis-investmentfromparticularcountrieswithapoorhumanrightsrecord,orpressuringabusinesstospeeduptheadoptionofenvironmentallyfriendlypoliciesandbuildabetterreputationforethicalbehaviour,etc.)

TheDivorcebetweenOwnership&ControlandBusinessConduct/ObjectivesWhatisMeantby“Short-Termism”?

• Short-termismiswhereacommercialbusinessprioritizesshort-termratherthanlong-termperformance

• Short-termismemphasisescertainperformancemeasures:o Shareprice(ifthecompanyislistedonastockexchange)o Revenuegrowtho Gross&operatingprofito Lowunitcosts&improvedproductivityo Rateofreturnoncapitalemployed

• Thismightbeattheexpenseofsuccessinmeetinglonger-termbusinessobjectives:o Marketshareo Qualityofproduct/serviceo Researchandinnovationo Brandreputationo Employeeskills&experienceo Socialresponsibility&sustainability

PossibleIndicatorsofShort-termism

• Bonusesbasedonshort-termobjectives

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• LowinvestmentinR&D• Highdividendpaymentsratherthanreinvestingprofits• Overuseoftakeoversratherthaninternalgrowth

TheMittelstandinGermany–AnAlternativetoShort-termism?

• Germanyhasmorethan1,000companiesthathavebeeninthesamefamilyforgenerationsbutcancompetewiththeworld’sbest.

• Thesecompaniesandover99percentofallGermancompaniesarepartofthe'Mittelstand',contributingnearly52percentofthecountry'seconomicoutputandemployingmorethan15millionpeople.

KeyFeaturesofMittelstandCompanies(andbusinessesthatare“long-termist)

• Familyownershiporfamily-likecorporateculture• Generationalcontinuity• Long-terminvestmentfocus&focusonR&D• Fiercelyindependent• Investmentintotheworkforce• Flexibility• Leanorganisationalhierarchies• Focusoninnovationandcustomerservice• Takecorporatesocialresponsibilityseriously

PublicandPrivateSectorOrganisationsPublicsectororganisationsarewhollyorpartlyownedandrunbythestate/government.ExamplesofpublicsectororganisationsintheUK

• BritishNuclearFuelsplc.• NetworkRail• BradfordandBingley• RoyalBankofScotland• Urenco–theUKgovernmenthasa33%stakeinthisuraniumenrichmentcompany• CompaniesHouse• TheMetOffice• OrdnanceSurvey• NuclearDecommissioningAuthority• TheUKgovernmentalsohasastakeinChannel4Television,Eurostar,theRoyalMintandthe

GreenInvestmentBankPrivatisation

• Privatisationmeansthetransferofassetsfromthepublic(stateorgovernment)sectortotheprivatesectorofaneconomy–privatisationcausesachangeofownership

• IntheUKtheprocesshasledtoareductioninthesizeofthepublicsector.• State-ownedenterprisesnowcontributelessthan2percentofGDPandonly1.5%oftotal

employment.• Privatisationhasbecomeacommonfeatureofmicro-economicreformsthroughoutthe

worldnotleastinmanytransitioneconomiesincludingalargenumberineasternEurope• ButoverrecentyearsprivatisationintheUKhasgivenwaytoanewwaveof

nationalizationincludingsomehighprofilebanks,buildingsocietiesandtransportservices.

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PrivatizationsintheUKovertheyears• AssociatedBritishPorts(1983)• BritishAerospace(1980)• BritishAirportsAuthority(1986)–boughtbyFerrovialin2006• BritishAirways(1987)• BritishCoal(1994)• BritishGas(1986)• BritishPetroleum–Graduallyprivatizedbetween1979and1987• BritishSteel(1988)• BritishTelecom(1984)• NationalPowerandPowerGen(1990)• Regionalwatercompanies• PlasmaResourcesUK–abloodplasmabusinesssoldtoBainCapitalin2013• BritishWaterways–whichbecameacharitabletrustin2012• TheTote–soldtoBetfredin2011• TheRoyalMail(2013)–fullyprivatizedin2016

ProfitandNot-for-ProfitOrganisationsProducerCooperatives

• Co-opsareownedandrunbytheirmembers,whocanbecustomers,employeesorgroupsofbusinesses.

• Thesupermarkets-to-funeralsCo-opGroupisthebiggest,followedbyJohnLewisPartnership,theretailer.

• Farmers’co-opsarepopularintheUK.• Otherco-opsincludecommunitypubs,supporter-runfootballclubsandfostercareand

localchildcareproviders• Thesebusinessesarefoundedandrunonprinciplesofsharedownership,sharedvoiceand

sharedprofits.SocialEnterprises

• Asocialenterpriseisanot-just-for-profitbusinesscreatedtoaddressasocialproblem• Profitsarereinvestedforoneormoresocialpurposesinthecommunity,ratherthanthe

needtosatisfyinvestors• In2013,researchfoundthattherewere70,000socialenterprisesintheUKcontributing

over£18bntotheeconomyandemployinghundredsofthousandsofpeople.• GoodexamplesofsocialenterprisesincludeJamieOliver’sFifteenrestaurantchain,theBig

IssuemagazineandtheEdenProjectinCornwallNotforProfit&NotforDividendFirms

• Notforprofitbusinessesarecharities,communityorganisationsthatarerunoncommerciallines

• NetworkRailisagoodexampletouse:o NetworkRail’spurposeistodeliverasafe,reliableandefficientrailwayforBritaino Itisacompanylimitedbyguarantee–whosedebtsaresecuredbythegovernmento NetworkRailisa"not-for-dividend"company-profitsareinvestedinthenetwork.o TrainoperatingcompaniessuchasFirstGreatWesternandVirginTrainspay

NetworkRailforuseoftherailinfrastructurewhenrunningserviceso NetworkRailisgiventargetsforpunctualityandsafetybytheRailRegulator

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TheBBCTheBBCrunsasapublicsectorenterprise,incomparisontoprivatesectorrivalslikeSkyandITV.AsizableproportionoftheBBC’sincomeisderivedfromcommercialactivities.AccordingtotheBBC's2013/14AnnualReport,itstotalincomewas£5,066millionbrokendownasfollows:

• £3,726millioninlicencefeescollectedfromhouseholders;• £1,023millionfromtheBBC'sCommercialBusinesses;• £245millionfromgovernmentgrants,ofwhich£239millionisfromtheForeignand

CommonwealthOfficefortheBBCWorldService;• £72millionfromotherincome,suchasrentalcollectionsandroyaltiesfromoverseas

broadcastsofprogrammingCorporateSocialResponsibility(CSR)Corporatesocialresponsibility(CSR)happenswhencompaniesintegratesocialandenvironmentalconcernsintotheirbusinessoperationsandintheirinteractionwiththeirstakeholdersonavoluntarybasis.SomereasonswhyfirmsareembracingCSRinclude:

1. Altruism–beingagoodcitizen2. Contractingbenefits–e.g.helpsrecruit,motivateandretaingoodqualityemployees3. Customer-relatedmotivation:attractcustomers;brandpositioning4. Improvedfinancialperformance:Sociallyresponsibleactionscanbeprofitable5. Lowerproductioncosts(i.e.lesspackaging,moreefficientenergyusage)6. Riskmanagement–addresspotentiallegalorregulatoryaction7. Improvedaccesstocapital–forexample,theriseethicalinvestmentfundslookingtomake

equityinvestmentsincompanieswithstrongCSRreputationsTheDebateonSocialResponsibility

• Notallbusinessorganisationsbehaveinasociallyresponsiblemanner• Somearguethatitisnotthejobofcommercialprivate-sectorbusinessestobeconcerned

aboutsocialissuesandproblemsTwoschoolsofthought:

1. Freemarketview:thejobofbusinessistocreatewealthforshareholders2. Corporatesocialresponsibilityview:businessshouldbeconcernedwithsocialissues

ThebusinesscaseagainstCSR:

• Theonlysocialresponsibilityofbusinessistocreateshareholderwealth• Theefficientuseofresourceswillbereducedifbusinessesarerestrictedinhowtheyact• Businessescannotdecidewhatisinsociety’sinterest• Extracostswillbeincurredwhichmustbepassedontoconsumers• CSRstiflesinnovation

Counter-arguments–theStakeholderView

• Businessesdonothaveanunquestionedrighttooperateinsociety• Thosemanagingbusinessshouldrecognisethattheydependonsociety• Businessreliesoninputsfromsocietyandonsociallycreatedinstitutions• Thereisasocialcontractbetweenbusinessandsocietyinvolvingmutualobligationsthat

societyandbusinessrecognisethattheyhavetoeachother

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BusinessGrowthHowbusinessesgrowOrganicgrowthOrganicgrowthisalsoknownasinternalgrowth.Ithappenswhenabusinessexpandsitsownoperationsratherthanrelyingontakeoversandmergers.Organicgrowthcancomeaboutfrom:

1. Increasingexistingproductioncapacitythroughinvestmentinnewcapital&technology2. Development&launchofnewproducts3. FindingnewmarketsbyexportingintoemergingcountriessuchasIndiaandSouthAfrica4. Growingacustomerbasethroughmarketing

CharacteristicsofBusinessesthatGrowSuccessfullyusingOrganicGrowth

1. Distinctivebrands&portfolios2. Usemarket&productdevelopment3. Resourcestosupportexpansion4. Sustainedinvestmentinnewproducts5. Strongdistributionchannels

RapidOrganicGrowthatCostaCoffee

UnderArmourgeneratesturnoverofaround$2bn

peryearandisconsistentlygrowingatover20%peryear.Itisdoingthisbyexpanding

theproductrange,extendingintoretail

operationsandpushingintoemergingmarkets

UnderArmour

WhitbreadownsCostaCoffeeandPremierInn-twobrandsthathave

performedexceptionallywelldespitetheeconomicdownturn.ThecompanyisBritain’sbiggestcoffee

shopchain.

Whitbread

TheLegobusinesshasnevermadean

acquisition.Itfocusesonusingnewproductdevelopmentand

innovationasthedriverofrevenuesandprofits.Since2007,Legohastripleditsrevenues

globally

Lego

8811,069

1,2171,392

1,5781,755

1,931

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ostaCoffee

stores

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Adidas–GrowthfromRetailPlatforms

OrganicGrowth–Apple’siPhone-GlobalUnitSalesSinceLaunch

BenefitsandDrawbacksofOrganicGrowthAdvantages Disadvantages

Lessriskthanexternalgrowth(e.g.takeovers) Growthachievedmaybedependentonthegrowthoftheoverallmarket

Canbefinancedthroughinternalfunds(e.g.retainedprofits)

Hardtobuildmarketshareifbusinessisalreadyaleader

Buildsonabusiness’strengths(e.g.brands,customers)

Slowgrowth–shareholdersmayprefermorerapidgrowth

Allowsthebusinesstogrowatamoresensiblerate

Franchises(ifused)canbehardtomanageeffectively

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Unitsalesinmillions

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BusinessGrowthfromIntegration

HorizontalintegrationHorizontalIntegrationoccurswhentwobusinessesinthesameindustryatthesamestageofproductionbecomingone.Somerecentexamples:

• Jan2016:UKDIYchainHomebasesoldtoAustralianretailgiantWesfarmersfor£340m• Dec2015:Domino'sbuyslargestGermanpizzachainfor$86m• Dec2015:USchemicalgiantsDuPontandDowChemicalCoagreetomergeindealworth

£86bn+planstosplitintothree.• Nov2015:Pfizer's$150bnpurchaseofofDublin-basedAllergan(themanufacturerof

Botoxproducts)• Nov2015:Marriottagreesa$12bnmergerwithSheratonhotelsownertocreateoneof

world’sbiggesthotelchains• Nov2015:ABInBev's£71bnbidforSABMiller–oneoftheworld’sbiggestbrewingmergers

inrecentyears• Nov2015:AstraZenecain$2.7bndealforbiotechfirmZSPharma• 2015:Horizontalmergersinthebettingindustry:LadbrokesandGalaCoral,Betfairand

PaddyPowerandGVCandBwin.partyAdvantagesofHorizontalIntegration

1. Businessescanexploitinternaleconomiesofscale(leadingtolowerLRAC)2. Costsavingsfromtherationalizationoftheenlargedbusiness–thisoftenthisinvolves

sizeablejoblosses3. Potentialtosecurerevenuesynergies4. Widerrangeofproducts-(i.e.throughdiversification)–thiscreatesopportunitiesfor

economiesofscope5. Reducescompetitionbyremovingkeyrivals–thisincreasestheirmarketshareandlong-

runpricingpower6. Buyinganexistingandwell-knownbrandcanbecheaperthanorganicallygrowingabrand

–thiscanthenmaketheentrybarriershigherforpotentialrivalsAgoodexampleofanindustrywherehorizontalintegrationhashappenedistheUKcinemaindustry.In2013,CineworldmadeabidtobuyPicturehouseandthiswaseventuallypassedbytheUKCompetitionandMarketsAuthority.Aninquiryin2013intoCineworld’sacquisitionofPicturehousefoundtherecouldbeasubstantiallesseningofcompetitionin3areas–Aberdeen,BuryStEdmundsandCambridge.CineworldandPicturehousefacedlimitedcompetitionhere,sotheacquisitioncouldleadtohigherpricesforlocalcinemagoers.CineworldwasrequiredtoselloneofthecinemasitownsineachoftheseareastoanoperatorapprovedbytheCompetitionandMarketsAuthority.InMarch2015,theCMAapprovedTheLightasasuitablepurchaserofthecinemainCambridgewhichmetitscriteria.Odeon,CineworldandVuedominatethemarketbasedonthenumberofscreens.

Backwardvertical Forwardvertical Horizontal Lateral Conglomerate

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ForwardandBackwardVerticalIntegrationVerticalintegrationmeansacquiringabusinessinthesameindustrybutatadifferentstageofthesupplychain.Itisthemergeroftwofirmsatadifferentstageofthesameindustryorprocessofproductionorsamefinalproduct.

1. Forwardvertical:Anintegrationofabusinessthatisclosertofinalconsumerse.g.amanufacturerbuyingaretailer

2. Backwardvertical:Closertotherawmaterialsinthesupplychaine.g.amanufacturerbuyingarawmaterialorcomponentsupplier

Examplesofverticalintegration

• Filmdistributorsowningcinemas+digitalstreamingplatforms• Brewersowning/operatingpubs(forwardvertical)orbuyinghopfarms(backwardvertical)• Recordlabelsandradio/onlinemusicstations• DrinksmanufacturerssuchasCocaColaintegratingwithbottlingplants• Pigprocessingbusinessbuyingapigfarm• Technologycompaniesgrowingverticallythroughhardware,softwareandservices• PayPal,acquiredbyeBayfor$1.5bnin2002• GooglebuyingMotorola,aphonemaker

Recentexamples:

• Nov2015:ApplebuysStarWarsmotion-capturecompanyFaceshift• Nov2015:IkeaBuysRomanian,BalticForeststoControlItsRawMaterials• Oct2015:Oct2015:Dellmakes$67bnbetonEMCintechhistory'slargestacquisition.US

computergiantDellagreestobuydatastoragecompanyEMC• Sept2015:(Wholesaler)Bookergivengreenlightfortakeoverdealworth£40mofBudgens

andLondisgrocerychains

879813

780264

1678262583935232321

663

0 100 200 300 400 500 600 700 800 900 1000

OdeonCineworld

VueNationalAmusements

EmpireCinemasOmniplex

ReelCinemasCineworld/PicturehouseMovieHouseCinemas

MerlinCinemasEverymanMediaGroup

LightCinemasCurzonCinemas

Others(19majorexhibitorsand290independent…

Screens

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VerticalIntegration-Advantages1. Controlofthesupplychain–thishelpstoreduceunitcostsandimprovethequalityof

inputsintotheproductionprocess2. Improvedaccesstokeyrawmaterialsperhapsattheexpenseofrivalbusinesses

(example?)3. Bettercontroloverretaildistributionchannels+addingnewchannelstoyoursales

platforms4. Removingsuppliersandmarketintelligencefromcompetitorswhichthenhelpstomakea

marketlesscontestable(increasesmarketpower)ConglomerateIntegration

• Aconglomeratehasalargenumberofdiversifiedbusinesses.• Theworld’sbiggestconglomeratesincludebusinessessuchasGeneralElectricand3Min

theUnitedStatesandSiemensfromGermany• AnotherisSamsung–theelectronicsgiantalsomakesmilitaryhardware,apartments,

shipsandSamsungalsooperatesaKoreanamusementpark!World'slargestconglomeratesasofApril22,2016,basedonmarketvalue(inbillionU.S.dollars)

Whydomanymergers/takeoversfail?

1. Hugefinancialcostsoffundingtakeoversincludingdealsthathavereliedonloanfinance-thisleavesabigdebtoverhangafterthedeal

2. Integratingsystems–companiesmighthaveverydifferenttechnologysystemsthatareexpensiveorimpossibletomarrye.g.eBay&Skype

3. Shareprice:Theneedtoraisefreshequitythrougharightsissuetofundadealwhichcanhaveanegativeimpactonacompany'sshareprice

4. Manymergersfailtoenhanceshareholdervaluebecauseofclashesofcorporatecultures,prioritiesandkeypersonalities

5. Theenlargedbusinessmaysufferalossofcustomersandalsosomeoftheirmostskilledworkerspostacquisition(alossofhumancapital)

6. Payingtoomuch:Withthebenefitofhindsightweseethe‘winnerscurse’-i.e.companiespayingovertheoddstotakecontrolofabusiness–thisisparticularlythecasewithtakeoversdrivenbymanagementego

7. Badtiming–mergersandtakeoversthattakeplacetowardstheendofasustainedboomcanoftenturnouttobedamagingforbothbusinesses

285.6102.2

91.888.486.9

66.448.248.1

42.126.3

0 50 100 150 200 250 300

GeneralElectric(U.S.)3M(U.S.)

Siemens(Germany)UnitedTechnologies(U.S.)

HoneywellInternational(U.S.)Danaher(U.S.)

CKHutchison(HongKong)ABB(Switzerland)

JardineMatheson(HongKong)Philips(Netherlands)

MarketvalueinbillionU.S.dollars

tutor2uEconomics


JointVentures• Jointventuresoccurwhenbusinessesjointogethertopursueacommonproject• Thebusinessesremainseparateinlegalterms• Jointventuresarebecomingcommonasfirmswanttobenefitfromcollaborativeworkin

reachingamutually-agreedstrategictarget.• Anexamplemightbejoint-researchprojectstosharethefixedcosts

JointVentures–RecentExamples

• Vodafone&Telefónicaagreedtosharetheirmobilenetwork• BMWandToyotaco-operateonresearchintohydrogenfuelcells,vehicleelectrification

andultra-lightweightmaterials• WestCoast–jointventurebetweenVirginRail&Stagecoach• GoogleandNASAdevelopingGoogleEarth• Hollywoodstudioscombiningtofightinternetpiracy• Alliancesinairlineindustrye.g.StarAllianceandOneWorld• Renault-Nissan• Docklands-LightRailway-ajointventurebetweenFrenchtransportgroupKeolisand

infrastructureservicesproviderAmey,partofSpanishmultinationalFerrovial.KeyConstraintsonBusinessGrowth

Regulation

• Growingbusinesseswinningsignificantmarketsharemaycometoattentionofthecompetitionauthoritiese.g.AmazonandGoogle

• IntheUK,theCompetitionandMarketsAuthority(CMA)maydecidetoblockamergerbetweentwofirmsiftheyfindsufficientevidencethatthemerger/takeoverwouldleadtoasubstantiallesseningofcompetitivepressureinamarket

Competition

• Incontestablemarketsthereisalwaysthethreatofentryfromrivalfirms;technologicalchangehasinmanycaseshadtheeffectofreducingbarrierstoentryintomarkets.

• Firmsthataredominantinanindustrybutoperatinginefficientlyandchargingmonopolypricesmayfindthatchallengersfirmsareabletoenterthemarketandcompeteawaysomeoftheirmarketshareandtheirsupernormalprofits.

Finance

Regulation Competition

Finance Size oftheMarket

edexcel a level economics year 2: microeconomics … a level economics year 2: microeconomics topics...

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