EdexcelALevelEconomics
Year2:MicroeconomicsTopics
CourseCompanion
Edition:September2016
www.tutor2u.net
tutor2uEconomics
Sizesandtypesoffirms......................................................................................................................4
SmallBusinesses.............................................................................................................................4
DivorcebetweenOwnershipandControl&thePrincipalAgentProblem....................................5
PublicandPrivateSectorOrganisations........................................................................................8
ProfitandNot-for-ProfitOrganisations..........................................................................................9
BusinessGrowth...............................................................................................................................11
Howbusinessesgrow...................................................................................................................11
BusinessGrowthfromIntegration...............................................................................................13
KeyConstraintsonBusinessGrowth............................................................................................16
Demergers........................................................................................................................................18
BusinessObjectives..........................................................................................................................19
ProfitMaximisation......................................................................................................................20
RevenueMaximisation.................................................................................................................20
SalesMaximisation.......................................................................................................................21
ProfitSatisficing............................................................................................................................22
Costs,revenuesandprofits..............................................................................................................24
Productionintheshortrun..........................................................................................................24
Costs.............................................................................................................................................25
Costsofproductionintheshortrun............................................................................................25
EconomiesandDiseconomiesofScale........................................................................................32
Longrunaveragecost(LRAC).......................................................................................................32
Revenues......................................................................................................................................39
Normalprofits,supernormalprofitsandlosses...........................................................................44
Profitmaximisationintheshortrun............................................................................................46
EconomicEfficiency..........................................................................................................................48
IntroductiontoMarketStructures...................................................................................................50
PerfectCompetition.........................................................................................................................53
AssumptionsoftheModel...........................................................................................................53
Profitmaximisationintheshortrun............................................................................................55
Profitmaximisationinthelongrun..............................................................................................55
Shutdownpriceandbreak-evenprice........................................................................................57
PerfectCompetitionandEfficiency..............................................................................................58
MonopolisticCompetition...............................................................................................................59
Assumptionsofthemodel...........................................................................................................59
Revenuecurvesinmonopolisticcompetition..............................................................................60
Profitmaximisationintheshortrun............................................................................................60
Profitmaximisationinthelongrun..............................................................................................60
Non-pricecompetition.................................................................................................................61
Monopolisticcompetitionandeconomicefficiency....................................................................62
Oligopoly..........................................................................................................................................63
Assumptionsofthemodel...........................................................................................................63
MeasuringMarketConcentration–TheN-FirmConcentrationRatio.........................................64
Non-collusiveoligopoly................................................................................................................65
GameTheory................................................................................................................................69
ThePrisoners’Dilemma...............................................................................................................70
PotentialBenefitsfromCollusion–AGameTheoryExample.....................................................72
FirstMoverAdvantageinMarkets...............................................................................................72
Open/FormalCollusioninanOligopoly......................................................................................74
CollusionandEfficiency................................................................................................................77
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Tacit/informalcollusion...............................................................................................................77
Monopoly.........................................................................................................................................78
NatureofMonopolyPowerinMarkets.......................................................................................78
MonopolyandProfitMaximisation.............................................................................................79
RevenueMaximisation.................................................................................................................80
NaturalMonopoly........................................................................................................................81
MonopolyandEfficiency..............................................................................................................83
PoliciestoRegulateMonopolyPower.........................................................................................85
PriceDiscrimination.........................................................................................................................86
Necessaryconditionsforpricediscrimination.............................................................................86
MainAimsofPriceDiscrimination...............................................................................................86
TypesofPriceDiscrimination/DynamicPricing..........................................................................87
PriceDiscriminationandEfficiency/Welfare..............................................................................90
Monopsony......................................................................................................................................91
Contestability...................................................................................................................................92
PricesandProfitsinaContestableMarket..................................................................................95
LabourMarket..................................................................................................................................97
DemandforLabour......................................................................................................................97
LabourSupply.............................................................................................................................100
LabourImmobility......................................................................................................................104
Wagedeterminationincompetitivelabourmarkets.................................................................105
Wagesandemploymentinimperfectlycompetitivelabourmarkets........................................107
MonopsonyintheLabourMarket.............................................................................................107
DiscriminationintheLabourMarket.........................................................................................109
TradeUnionsintheLabourMarket...........................................................................................111
LabourMarketFailure&GovernmentIntervention..................................................................115
MinimumWagesintheLabourMarkets....................................................................................116
KeyLabourMarketIssuesandDatafortheUK..........................................................................119
GovernmentIntervention..............................................................................................................126
Governmentinterventiontocontrolmergers...........................................................................127
Governmentinterventiontocontrolmonopolies......................................................................128
Interventiontopromotecompetitionandcontestability..........................................................131
Governmentinterventiontoprotectsuppliersandemployees.................................................135
Impactofgovernmentintervention...........................................................................................137
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Sizesandtypesoffirms
SmallBusinesses
ThebulkofbusinessesregisteredintheUKeconomyaresmall.
Whydomanysmallfirmssurvive?
Themedianprofitofsmall&mediumsizedenterprisesintheUKin2014was£8,000.Yetmany
smallbusinessescontinuetosurviveandgrow:
1. Manysmallerbusinessesactasasupplier/sub-contractortomuchlargerenterprises
especiallyintheconstructionindustry
2. Theymighttakeadvantageofalowpriceelasticityofdemandandhighincome-elasticity
forspecialist‘niche’productswhichcanbesoldatahigherpricewithalargeprofitmargin
3. Smallerbusinessescanavoiddiseconomiesofscale(risingaveragecost)
4. Manysmallerbusinessesrunaslifestyleenterprises,suggestingthattheirownersare
lookingtoachieveasatisfactoryreturnratherthanmaximumprofits
5. Small-scalebusinessesareoftenmoreinnovative,flexibleandnimbleinrespondingto
changesinmarketdemandconditions
6. Smallbusinesseshavebenefittedfromtherisingpercentageofconsumerswillingtobuy
online–thebarrierstoentryintothemarkethavecomedownbecauseofdigital
technology(e.g.techstart-ups)
SmallerFirms&BusinessObjectives
Manysmallerfirmshavedifferentbusinessobjectivestolarger,scaledcorporations:
TypicalObjective
RelevancetoSmallerFirms
BusinessSurvival
Akeyobjectiveforstart-upfirmsandmanysmallerfirms.Whilstsmallfirms
havelowercosts,over-relianceononeorafewproductscanthreatensurvival.
Revenue
Maximisation
Rarelyakeyobjectiveforsmallerfirms,althoughtheyareoftenkeentogrow
salesalbeitfromalowbaselevel.
ProfitMaximisation
Smallerfirmswillnormallyearnlowerabsolutelevelsofprofit(becausetheir
revenuesarelower).However,theycanstillachievehighprofitmarginsif
operatinginasuitablenichemarket.
CostEfficiency&Scale Smallerfirmsareunlikelytobenefitfromeconomiesofscalealthoughthey
maybegoodatkeepingtheircostbaselow.
CustomerService
Smallerfirmsareoftenassociatedwithhigherlevelsofcustomerserviceand
satisfaction,oftenbecausethebusinessowneriscloselyinvolvedwiththe
provisionofcustomerservice.
SomeKeyReasonstoStaySmall
• Productdifferentiation&USP(uniquesellingpoint)
o Positioningabusinessas“small”canhelpdifferentiateagainstlargercompetitors
o Customerperceptionmaybeanexpectationofabetterproductfromabusiness
that“cares”
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•
•
•
•
•
o Morescopeforaddingvaluethroughsellingspecialistexpertise(e.g.advice)
Flexibilityinmeetingcustomerneeds
o Manysmallbusinessestalktotheircustomersregularly;sometimeeveryday
o Smallfirmsoftencommunicateinthecustomers’languagewhichgivethe
impressiontothecustomerthattheyaremoreintunewiththeirneeds
o Makesiteasiertogetcustomerfeedback(largerfirmsoftenstrugglewiththis)
Deliverhighstandardofcustomerservice
o Mostsmallbusinessesoperateinthe“service”sector,sothisisakeysourceof
competitiveadvantage
o Employeesinsmallerfirmsarelikelytotreatcustomerserviceasapriority
(comparedwithlargerfirms)thoughthereisnoguarantee!
Exploitopportunitiesfrome-commerce
o E-commerceisanobvious(andincreasinglycommon)wayforsmallfirmstoreacha
broadercustomerbase
o Itisnowrelativelyeasyforasmallfirmtotargetnichesegmentsbothdomestically
andoverseasusinge-commerce
o Smallerfirms,providedtheyareconfidentwithitsuse,cangainsignificanttraction
withcustomersusingsocialmedia
Avoidrisksfromdiseconomiesofscale
Smallerfirmscanbemoreinnovative/creative
DivorcebetweenOwnershipandControl&thePrincipalAgentProblem
ShareholdersandStakeholdersinaBusiness
• Stakeholders:
o Astakeholderisanyindividualororganisationwhohasavestedinterestinthe
activitiesanddecisionmakingofabusiness
• Shareholders:
o Ownthebusiness–theyhaveanequitystakeinthebusiness-perhapsafounder
o Mayalsoworkinthebusiness
o Mainlyinterestedingrowingthevalueoftheirshareholding
§ Capitalgain–anincreaseinthemarketvalueofashare
§ Dividends–ashareoftheprofitsmadebyabusiness
WhatStakeholdersAreInterestedIn
Stakeholder
Mainlyinterestedin:
Shareholders/
Owners
Returnoninvestment+profitsanddividends
Successandgrowthofthebusiness
Properrunningofthebusiness
Managers&
Employees
Rewards,includingbasicpayandotherfinancialincentives
Jobsecurity&workingconditions
Promotionopportunities+jobsatisfaction&status–motivation,rolesand
responsibilities
Customers
Valueformoney
Productquality&customerservice
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Suppliersinthe
market
Banks&otherfinance
providers
Continued,profitabletradewiththebusiness
Financialstability–canthebusinesspayitsbills?
Canthebusinessrepayamountsloanedorinvested?
Profitabilityandcashflowsofthebusiness
Growthinprofitsandvalueofthebusiness
Government
Thecorrectcollectionandpaymentoftaxes(e.g.VAT)
Helpingthebusinesstogrow–creatingjobs
Compliancewithbusinesslegislation
Localcommunity
Successofthebusiness–particularlycreatingandretainingjobs
Compliancewithlocallawsandregulations(e.g.noise,pollution)
PotentialConflictsbetweenStakeholders
BusinessDecision
Likelytobe
SupportedBy
Possibly
OpposedBy?
Cutjobstoreducecosts
Addextrashiftstoincreasefactory
capacity
Shareholders
Banks
Management
Customers&suppliers
Employees
Localcommunity
Localcommunity
Introducenewmachinerytoreplace
manualwork
Customers
Shareholders
Employees
Increasesellingpricessignificantlyto
improveprofitmargins
Shareholders
Management
Customers
TheDivorcebetweenOwnershipandControl
Inmostbusinessesthereisadivorcebetweenownershipandcontrol.Inotherwords,theowners
ofabusinessmaynotbethesamepeopleasthosewhoaretakingkeyday-to-daydecisions.
Agencyproblem
Stakeholders
Stakeholderconflict
Possibleconflictsofinterestthatmayresultbetween
shareholders(principal)andthemanagement(agent)ofa
firm
Inmostbusinessestherearemanydifferentstakeholders.
Theseincludecustomers,managers,employees,
shareholders,debtholdersandthegovernment
Stakeholderconflictoccurswhendifferentstakeholdershave
differentobjectives.Firmshavetochoosebetween
maximizingoneobjectiveandsatisfactorilymeetingseveral
stakeholderobjectives,socalledsatisficing
PrincipalAgentProblem
Theprincipalagentproblemisanasymmetricinformationproblem.Theownersofafirmoften
cannotobservedirectlytheday-to-daydecisionsofmanagement.Decisionsandperformanceof
theagentarecostlyanddifficulttomonitor.
• Principal
o Ownerofthebusiness
• Hiresanagent
o e.g.salesorfinancemanager
• Managers
o Mayhavedifferentbusinessobjectives
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OvercomingThePrincipalAgentProblem
Whatisinthebestinterestofthemanagementisnotnecessarilythesameaswhatisinthe
optimuminterestsoftheshareholders.Strategiesinvolvetryingtoaligntheaimsofthesetwo
differentstakeholders.
• Employeeshareownershipschemes
o JohnLewisandWaitrosehaveahighly-regardedpartnershipmodel
o Stockoptionsmightleadtoperversebehaviour–e.g.deliberateattemptstohike
upsharepricesthroughillegalaction(thinkbacktothecaseofEnron)
• Longtermemploymentcontractsforseniormanagement
o Securityoftenuremightencouragemanagerstotakedecisionsinthelongterm
bestinterestsofthebusiness
• Longtermstockcommitment
o Apple’snewpolicy(2013)requiresseniorexecutivesatAppletoholdthreetimes
theirannualbasesalaryinstock,andexecutiveshavetokeepthissalaryinstockfor
aminimumoffiveyearstosatisfytherequirement
Activistshareholders
• Activistshareholderslooktoputpressureonexistingmanagementorforcethrough
changestomanagementboards.
• Someinsistonbusinessesusingprofitstobuy-backsharestoincreasereturnstoexisting
shareholders.
• Anactivistshareholderusesanequitystaketoputpressureonexistingmanagement.
• Thegoalsofactivistshareholderscanrangefromfinancial(e.g.increaseofshareholder
valuethroughchangesindividenddecisions,plansforcostcuttingorinvestmentprojects
etc.)tonon-financial(e.g.dis-investmentfromparticularcountrieswithapoorhuman
rightsrecord,orpressuringabusinesstospeeduptheadoptionofenvironmentally
friendlypoliciesandbuildabetterreputationforethicalbehaviour,etc.)
TheDivorcebetweenOwnership&ControlandBusinessConduct/Objectives
WhatisMeantby“Short-Termism”?
• Short-termismiswhereacommercialbusinessprioritizesshort-termratherthanlong-term
performance
• Short-termismemphasisescertainperformancemeasures:
o Shareprice(ifthecompanyislistedonastockexchange)
o Revenuegrowth
o Gross&operatingprofit
o Lowunitcosts&improvedproductivity
o Rateofreturnoncapitalemployed
• Thismightbeattheexpenseofsuccessinmeetinglonger-termbusinessobjectives:
o Marketshare
o Qualityofproduct/service
o Researchandinnovation
o Brandreputation
o Employeeskills&experience
o Socialresponsibility&sustainability
PossibleIndicatorsofShort-termism
• Bonusesbasedonshort-termobjectives
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•
•
•
LowinvestmentinR&D
Highdividendpaymentsratherthanreinvestingprofits
Overuseoftakeoversratherthaninternalgrowth
TheMittelstandinGermany–AnAlternativetoShort-termism?
• Germanyhasmorethan1,000companiesthathavebeeninthesamefamilyfor
generationsbutcancompetewiththeworld’sbest.
• Thesecompaniesandover99percentofallGermancompaniesarepartofthe
'Mittelstand',contributingnearly52percentofthecountry'seconomicoutputand
employingmorethan15millionpeople.
KeyFeaturesofMittelstandCompanies(andbusinessesthatare“long-termist)
• Familyownershiporfamily-likecorporateculture
• Generationalcontinuity
• Long-terminvestmentfocus&focusonR&D
• Fiercelyindependent
• Investmentintotheworkforce
• Flexibility
• Leanorganisationalhierarchies
• Focusoninnovationandcustomerservice
• Takecorporatesocialresponsibilityseriously
PublicandPrivateSectorOrganisations
Publicsectororganisationsarewhollyorpartlyownedandrunbythestate/government.
ExamplesofpublicsectororganisationsintheUK
•
•
•
•
•
•
•
•
•
•
BritishNuclearFuelsplc.
NetworkRail
BradfordandBingley
RoyalBankofScotland
Urenco–theUKgovernmenthasa33%stakeinthisuraniumenrichmentcompany
CompaniesHouse
TheMetOffice
OrdnanceSurvey
NuclearDecommissioningAuthority
TheUKgovernmentalsohasastakeinChannel4Television,Eurostar,theRoyalMintandthe
GreenInvestmentBank
Privatisation
• Privatisationmeansthetransferofassetsfromthepublic(stateorgovernment)sectorto
theprivatesectorofaneconomy–privatisationcausesachangeofownership
• IntheUKtheprocesshasledtoareductioninthesizeofthepublicsector.
• State-ownedenterprisesnowcontributelessthan2percentofGDPandonly1.5%oftotal
employment.
• Privatisationhasbecomeacommonfeatureofmicro-economicreformsthroughoutthe
worldnotleastinmanytransitioneconomiesincludingalargenumberineasternEurope
• ButoverrecentyearsprivatisationintheUKhasgivenwaytoanewwaveof
nationalizationincludingsomehighprofilebanks,buildingsocietiesandtransportservices.
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PrivatizationsintheUKovertheyears
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•
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•
•
•
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-ProfitOrganisations
ProducerCooperatives
• Co-opsareownedandrunbytheirmembers,whocanbecustomers,employeesorgroups
ofbusinesses.
• Thesupermarkets-to-funeralsCo-opGroupisthebiggest,followedbyJohnLewis
Partnership,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
IssuemagazineandtheEdenProjectinCornwall
NotforProfit&NotforDividendFirms
• Notforprofitbusinessesarecharities,communityorganisationsthatarerunon
commerciallines
• NetworkRailisagoodexampletouse:
o NetworkRail’spurposeistodeliverasafe,reliableandefficientrailwayforBritain
o Itisacompanylimitedbyguarantee–whosedebtsaresecuredbythegovernment
o NetworkRailisa"not-for-dividend"company-profitsareinvestedinthenetwork.
o TrainoperatingcompaniessuchasFirstGreatWesternandVirginTrainspay
NetworkRailforuseoftherailinfrastructurewhenrunningservices
o NetworkRailisgiventargetsforpunctualityandsafetybytheRailRegulator
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TheBBC
TheBBCrunsasapublicsectorenterprise,incomparisontoprivatesectorrivalslikeSkyandITV.A
sizableproportionoftheBBC’sincomeisderivedfromcommercialactivities.Accordingtothe
BBC's2013/14AnnualReport,itstotalincomewas£5,066millionbrokendownasfollows:
• £3,726millioninlicencefeescollectedfromhouseholders;
• £1,023millionfromtheBBC'sCommercialBusinesses;
• £245millionfromgovernmentgrants,ofwhich£239millionisfromtheForeignand
CommonwealthOfficefortheBBCWorldService;
• £72millionfromotherincome,suchasrentalcollectionsandroyaltiesfromoverseas
broadcastsofprogramming
CorporateSocialResponsibility(CSR)
Corporatesocialresponsibility(CSR)happenswhencompaniesintegratesocialandenvironmental
concernsintotheirbusinessoperationsandintheirinteractionwiththeirstakeholdersona
voluntarybasis.SomereasonswhyfirmsareembracingCSRinclude:
1. Altruism–beingagoodcitizen
2. Contractingbenefits–e.g.helpsrecruit,motivateandretaingoodqualityemployees
3. Customer-relatedmotivation:attractcustomers;brandpositioning
4. Improvedfinancialperformance:Sociallyresponsibleactionscanbeprofitable
5. Lowerproductioncosts(i.e.lesspackaging,moreefficientenergyusage)
6. Riskmanagement–addresspotentiallegalorregulatoryaction
7. Improvedaccesstocapital–forexample,theriseethicalinvestmentfundslookingtomake
equityinvestmentsincompanieswithstrongCSRreputations
TheDebateonSocialResponsibility
• Notallbusinessorganisationsbehaveinasociallyresponsiblemanner
• Somearguethatitisnotthejobofcommercialprivate-sectorbusinessestobeconcerned
aboutsocialissuesandproblems
Twoschoolsofthought:
1. Freemarketview:thejobofbusinessistocreatewealthforshareholders
2. Corporatesocialresponsibilityview:businessshouldbeconcernedwithsocialissues
ThebusinesscaseagainstCSR:
• Theonlysocialresponsibilityofbusinessistocreateshareholderwealth
• Theefficientuseofresourceswillbereducedifbusinessesarerestrictedinhowtheyact
• Businessescannotdecidewhatisinsociety’sinterest
• Extracostswillbeincurredwhichmustbepassedontoconsumers
• CSRstiflesinnovation
Counter-arguments–theStakeholderView
• Businessesdonothaveanunquestionedrighttooperateinsociety
• Thosemanagingbusinessshouldrecognisethattheydependonsociety
• Businessreliesoninputsfromsocietyandonsociallycreatedinstitutions
• Thereisasocialcontractbetweenbusinessandsocietyinvolvingmutualobligationsthat
societyandbusinessrecognisethattheyhavetoeachother
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BusinessGrowth
Howbusinessesgrow
Organicgrowth
Organicgrowthisalsoknownasinternalgrowth.Ithappenswhenabusinessexpandsitsown
operationsratherthanrelyingontakeoversandmergers.
Organicgrowthcancomeaboutfrom:
1. Increasingexistingproductioncapacitythroughinvestmentinnewcapital&technology
2. Development&launchofnewproducts
3. FindingnewmarketsbyexportingintoemergingcountriessuchasIndiaandSouthAfrica
4. Growingacustomerbasethroughmarketing
UnderArmour
Whitbread
UnderArmourgenerates
turnoverofaround$2bn
peryearandis
consistentlygrowingat
over20%peryear.Itis
doingthisbyexpanding
theproductrange,
extendingintoretail
operationsandpushing
intoemergingmarkets
WhitbreadownsCosta
CoffeeandPremierInntwobrandsthathave
performedexceptionally
welldespitetheeconomic
downturn.Thecompanyis
Britain’sbiggestcoffee
shopchain.
Lego
TheLegobusinesshas
nevermadean
acquisition.Itfocuseson
usingnewproduct
developmentand
innovationasthedriverof
revenuesandprofits.
Since2007,Legohas
tripleditsrevenues
globally
NumberofCostaCoffee
stores
CharacteristicsofBusinessesthatGrowSuccessfullyusingOrganicGrowth
1. Distinctivebrands&portfolios
2. Usemarket&productdevelopment
3. Resourcestosupportexpansion
4. Sustainedinvestmentinnewproducts
5. Strongdistributionchannels
RapidOrganicGrowthatCostaCoffee
2500
2000
1500
1000
881
1,069
1,217
1,392
1,578
1,755
1,931
500
0
2008/09
2009/10
2010/11
2011/12
2012/13
2013/14
2014/15
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Adidas–GrowthfromRetailPlatforms
Conceptstores
Factoryoutlets
Concessioncornersandother
Numberofstores
3000
2500
2000
1500
1000
500
0
2008
2009
2010
2011
2012
2013
2014
Year
Unitsalesinmillions
OrganicGrowth–Apple’siPhone-GlobalUnitSalesSinceLaunch
80
70
60
50
40
30
20
10
0
Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3
'07 '08 '08 '09 '09 '10 '10 '11 '11 '12 '12 '13 '13 '14 '14 '15 '15 '16 '16
BenefitsandDrawbacksofOrganicGrowth
Advantages
Disadvantages
Lessriskthanexternalgrowth(e.g.takeovers) Growthachievedmaybedependentonthe
growthoftheoverallmarket
Canbefinancedthroughinternalfunds(e.g.
retainedprofits)
Buildsonabusiness’strengths(e.g.brands,
customers)
Allowsthebusinesstogrowatamore
sensiblerate
Hardtobuildmarketshareifbusinessis
alreadyaleader
Slowgrowth–shareholdersmayprefermore
rapidgrowth
Franchises(ifused)canbehardtomanage
effectively
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BusinessGrowthfromIntegration
Backwardvertical
Forwardvertical
Horizontal
Lateral
Conglomerate
Horizontalintegration
HorizontalIntegrationoccurswhentwobusinessesinthesameindustryatthesamestageof
productionbecomingone.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.party
AdvantagesofHorizontalIntegration
1. Businessescanexploitinternaleconomiesofscale(leadingtolowerLRAC)
2. Costsavingsfromtherationalizationoftheenlargedbusiness–thisoftenthisinvolves
sizeablejoblosses
3. Potentialtosecurerevenuesynergies
4. Widerrangeofproducts-(i.e.throughdiversification)–thiscreatesopportunitiesfor
economiesofscope
5. Reducescompetitionbyremovingkeyrivals–thisincreasestheirmarketshareandlongrunpricingpower
6. Buyinganexistingandwell-knownbrandcanbecheaperthanorganicallygrowingabrand
–thiscanthenmaketheentrybarriershigherforpotentialrivals
AgoodexampleofanindustrywherehorizontalintegrationhashappenedistheUKcinema
industry.In2013,CineworldmadeabidtobuyPicturehouseandthiswaseventuallypassedbythe
UKCompetitionandMarketsAuthority.Aninquiryin2013intoCineworld’sacquisitionof
Picturehousefoundtherecouldbeasubstantiallesseningofcompetitionin3areas–Aberdeen,
BuryStEdmundsandCambridge.CineworldandPicturehousefacedlimitedcompetitionhere,so
theacquisitioncouldleadtohigherpricesforlocalcinemagoers.Cineworldwasrequiredtosell
oneofthecinemasitownsineachoftheseareastoanoperatorapprovedbytheCompetitionand
MarketsAuthority.InMarch2015,theCMAapprovedTheLightasasuitablepurchaserofthe
cinemainCambridgewhichmetitscriteria.Odeon,CineworldandVuedominatethemarket
basedonthenumberofscreens.
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Screens
0
Odeon
Cineworld
Vue
NationalAmusements
EmpireCinemas
Omniplex
ReelCinemas
Cineworld/Picturehouse
MovieHouseCinemas
MerlinCinemas
EverymanMediaGroup
LightCinemas
CurzonCinemas
Others(19majorexhibitorsand290independent…
100 200 300 400 500 600 700 800 900 1000
879
813
780
264
167
82
62
58
39
35
23
23
21
663
ForwardandBackwardVerticalIntegration
Verticalintegrationmeansacquiringabusinessinthesameindustrybutatadifferentstageof
thesupplychain.Itisthemergeroftwofirmsatadifferentstageofthesameindustryorprocess
ofproductionorsamefinalproduct.
1. Forwardvertical:Anintegrationofabusinessthatisclosertofinalconsumerse.g.a
manufacturerbuyingaretailer
2. Backwardvertical:Closertotherawmaterialsinthesupplychaine.g.amanufacturer
buyingarawmaterialorcomponentsupplier
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
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VerticalIntegration-Advantages
1. Controlofthesupplychain–thishelpstoreduceunitcostsandimprovethequalityof
inputsintotheproductionprocess
2. Improvedaccesstokeyrawmaterialsperhapsattheexpenseofrivalbusinesses
(example?)
3. Bettercontroloverretaildistributionchannels+addingnewchannelstoyoursales
platforms
4. Removingsuppliersandmarketintelligencefromcompetitorswhichthenhelpstomakea
marketlesscontestable(increasesmarketpower)
ConglomerateIntegration
• Aconglomeratehasalargenumberofdiversifiedbusinesses.
• Theworld’sbiggestconglomeratesincludebusinessessuchasGeneralElectricand3Min
theUnitedStatesandSiemensfromGermany
• AnotherisSamsung–theelectronicsgiantalsomakesmilitaryhardware,apartments,
shipsandSamsungalsooperatesaKoreanamusementpark!
World'slargestconglomeratesasofApril22,2016,basedonmarketvalue(inbillionU.S.dollars)
MarketvalueinbillionU.S.dollars
0
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)
50
100
150
200
250
300
285.6
102.2
91.8
88.4
86.9
66.4
48.2
48.1
42.1
26.3
Whydomanymergers/takeoversfail?
1. Hugefinancialcostsoffundingtakeoversincludingdealsthathavereliedonloanfinance-
thisleavesabigdebtoverhangafterthedeal
2. Integratingsystems–companiesmighthaveverydifferenttechnologysystemsthatare
expensiveorimpossibletomarrye.g.eBay&Skype
3. Shareprice:Theneedtoraisefreshequitythrougharightsissuetofundadealwhichcan
haveanegativeimpactonacompany'sshareprice
4. Manymergersfailtoenhanceshareholdervaluebecauseofclashesofcorporatecultures,
prioritiesandkeypersonalities
5. Theenlargedbusinessmaysufferalossofcustomersandalsosomeoftheirmostskilled
workerspostacquisition(alossofhumancapital)
6. Payingtoomuch:Withthebenefitofhindsightweseethe‘winnerscurse’-i.e.companies
payingovertheoddstotakecontrolofabusiness–thisisparticularlythecasewith
takeoversdrivenbymanagementego
7. Badtiming–mergersandtakeoversthattakeplacetowardstheendofasustainedboom
canoftenturnouttobedamagingforbothbusinesses
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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
Competition
Finance
Size ofthe
Market
Regulation
• Growingbusinesseswinningsignificantmarketsharemaycometoattentionofthe
competitionauthoritiese.g.AmazonandGoogle
• IntheUK,theCompetitionandMarketsAuthority(CMA)maydecidetoblockamerger
betweentwofirmsiftheyfindsufficientevidencethatthemerger/takeoverwouldleadto
asubstantiallesseningofcompetitivepressureinamarket
Competition
• Incontestablemarketsthereisalwaysthethreatofentryfromrivalfirms;technological
changehasinmanycaseshadtheeffectofreducingbarrierstoentryintomarkets.
• Firmsthataredominantinanindustrybutoperatinginefficientlyandchargingmonopoly
pricesmayfindthatchallengersfirmsareabletoenterthemarketandcompeteaway
someoftheirmarketshareandtheirsupernormalprofits.
Finance
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