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Unit 4 - Industrial Economics

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Module 2881 Industrial Economics Unit 4: “The Theory of Production & Costs”

4-1. THE GROWTH OF FIRMS The Birth of Firms

Firms usually start small, often as a one-person concern or a family concern. According to Barclays Bank, some 465,000 new firms started up in 2003 alone. Sadly, Sadly, many of these are doomed to fail. fail. According to government government statistics, in 1997, the  business survival rate for new firms was only 65.1 per cent after three years; one third had disappeared in that period. About half of these close down voluntarily, voluntarily, and about a third sell the business to another firm. In many cases they are undercapitalised, and the firm simply runs out of money and cannot borrow any more. more. In some cases it is a management management constraint, constraint, in that the  person is ambitious but not talented or skilful enough. Virtually all firms have to  borrow to invest and grow. grow.

Why do firms wish to grow?

The usual motives are: • • •

To make higher profits. To establish a business that will see them through life. To leave a legacy for their dependents and perhaps to establish a dynasty.

Reasons for success are harder to pin down, but include: • • • • • •

Sufficient capital to tide the firm over a bad patch. Access to funds. Good contacts. Willingness Willingness to work long hours. Developing a strategy strategy to overcome local or regional regional disadvantages in location. Developing a niche market or a unique selling point.

The desire for to grow leads firm to try try to increase their share of the market. market. The really successful ones may gain economies of scale and a few might become monopolies or be large enough to compete with the big boys.

Copyright Kevin Bucknall ©

Chap 4 - 1

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4-2. THE MOTIVES OF FIRMS

1. Profit maximisation.

In economic theory, theory, the main motive for a firm is to maximise profits. This is central to mainstream theory. theory. It involves equating marginal cost with marginal revenue, whatever  the market situation the firm is experiencing. 2. Revenue maximisation

This is another suggested goal. It would be possible for a firm to survive following following this goal but it would grow more more slowly and always always be a bit at at risk. A lusty profit maximiser could seize an increasing share of the market, possibly driving the revenue maximiser out in the longer term. Using our diagrams, instead of the firm seeking the point where MC=MR as a profit maximiser would, the revenue maximiser keeps expanding output as long as marginal revenue is positive. It ceases to be positive where it cuts the horizontal axis at Q in the diagram below. below. As soon as it becomes negative, total revenue would start to fall, so the firm stops.

Price, costs, Revenue MC AC P AR  0

Q

MR 

Quantity

In the above diagram, the revenue maximising quantity is thus OQ and the price is then read off the demand curve: the firm chooses price OP. OP. Because the firm reduces price until marginal revenue becomes negative, there is an implication for the elasticity elasticity of demand. demand. If a price reduction leads leads to an increase in total revenue, we know that demand is elastic. If a price reduction leads to a fall in total revenue we know that demand is inelastic. inelastic. As we switch from increasing increasing to falling total

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3. Sales maximisation

This is a third suggested goal. It suffers suffers from the same problem of the revenue maximisers, in that the firm is vulnerable to profit seeking competitors. Such a firm will expand output until the average cost curve intersects the demand curve, as in the diagram diag ram below. below.

Price, costs, Revenue MC AC

P 0

AR  MR 

Q

Quantity

The firm produces OQ level of output and sells it for price P. P. This price is lower than the profit maximiser’s price, or the revenue maximiser’s price – as one would expect as more sales is what it is all about. A variant of this model is that the firm may concentrate on maximising sales in the short term in order to gain a larger share of the market so that in the long term it can earn more profits by switching switching its goal. It is a sort of long term profit maximiser using the route of short term sales maximisation! Another business variant model of the sales maximiser is that it is possible that when the firm becomes large, managers are taken on and they may prefer to maximise sales rather than profits. The shareholders would would generally prefer higher higher profit but they have little say in day to day running of a company.

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4-3. THE EXTERNAL GROWTH OF FIRMS:

Mergers

A firm may may grow by merging with, or taking over, another firm. There are two directions in which it can do this: horizontal horizontal and vertical. These refer to the position position of  the other firm within the structure of the industry. industry. Horizontal mergers

This is when a firm merges with another at the same level within the industry. industry. As an example, if one video rental rental firm takes over another video rental rental firm. In effect they exist at the same level and they they do the same things. They are probably directly directly in competition with each other, although some may be located differently. A recent example of this occurred in 2004 when the supermarket Morrison took over Safeway; Safeway; Morrison was strong strong in the north of England but lacked southern southern outlets. It is, as you would imagine, difficult for a supermarket to obtain suitable land in or near cities, so that a take-over or merger is the simplest way of expanding into a new area.

Vertical mergers

This is when a firm takes over another which is earlier or later in the production process within the industry. As an example, a wholesaler of shoes might take over a shoe shop or chain of shoe shops, in order to to provide itself with outlets. outlets. This is an example of  manufacturing company, company, it would be an  forward merger . If it were to take over a shoe manufacturing example of backward takeover . A current example of a backward merger merger is the effort in 2004 by the American Wal-Mart Wal-Mart company, trading in Britain as Asda, to develop a close partnership over a section of the milk supply industry at the farm level. Some such mergers are an effort to reduce risks and establish a safe source of supply or  outlet chain. However, many backward mergers by a dominant firm are an effort to reduce competition and perhaps lead to a later take over the whole industry. industry. Once a wholesaler  owns an an important important manufacturing unit it it can deny the produce to its own more more direct direct competitors or make them buy on less advantageous terms. There are fears that Asda’s Asda’s recent efforts in the milk chain supply industry could lead to a less competitive situation.

Conglomerate mergers

This is where a company in one industry takes over one or more companies in a totally unconnected industry. industry. The result will be a conglomerate, conglomerate, or a company which spans several unconnected industries. A contemporary example is Richard Branson’s Branson’s Virgin, Virgin,

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have loose connections, others none. In all he now owns over 150 companies and claims that they all make money. money.

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4-4. MULTINATION MULTINATION CORPORATIONS

Multinational corporations (MNC’s) have grown in importance as globalisation  proceeded and they are a factor in encouraging encouraging the globalisation globalisation process. An MNC is typically a huge corporation spanning several continents with one home base, which might be in the UK, the USA, Holland, France, Japan…. it can be anywhere but is almost always in the country in which it first began. Some are the result of mergers, horizontal or vertical, as a company in country A takes takes over an existing company in a different country. country. Others are the result of the original company in country A investing money in country B to build a factory or firm there. You will certainly have heard about a lot of MNC’s, even if you did not know that this is what they were! Well-known examples are Ford (motor vehicles), Unilever, Unilever, Sony, IBM, Philips, and Reckitt and Colman. These large companies have huge sums to invest and the world is their oyster. They often try to locate production where the manufacturing costs will be low, so recipient countries include places like China, India, Indonesia, Pakistan and Thailand. Various service centres will normally be established to cover the different parts of the world. In the last half of the twentieth century, globalisation was rapid. It was assisted by a huge fall in the costs of communication and finding information, as well as by tariff  cuts and quota reductions or elimination. MNC’s MNC’s took advantage and grew rapidly as  part of this; in addition they were responsible for pressuring governments to take action, such as tariff cuts, which helped the MNC’s to expand. By the end of the last century, trade between multi-nationals themselves has been estimated to account for  one third of world trade, and another third is made up of trade by MNC’s with nonaffiliates. They are indeed major players! We return to look at MNC’s, what they do and the arguments for and against them in Unit 6.

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4-5. AN INTRODUCTION INTRODUCTION TO PRODUCTION THEORY AND COSTS COSTS

Production theory underlies all the theory of the firm, it is related to resource allocation, and it is where we get the supply curve from. We assume for simplification: •

A one-product one-produ ct firm.



We can identify land, labour and the units of capital used, as well as costs.



Land, labour and capital are homogeneous, homogeneou s, which means they are all identical.



Firms aim to maximise profits. Other models do exist, e.g. sales maximisation,  but they are not a part of central  economic theory. theory.

Profits

Profits Profits are not a dirty word! word! But what some people people will do for profit can be very dirty indeed! indeed! It is alleged that the Mafia in the USA will give you a cheap quote for removing and dealing with your toxic waste - then they might just tip it into reservoirs to get rid of it, and not spend the money to do it properly.

The function of profits: (what are they for?)

Profits are a signal - a high rate of profit in an industry is a signal that society values that particular good or service highly and and will pay a lot to get it. This tells us that more resources should go into this industry that that society values so much. Individual firms move in to get the profit and as a result, resources automatically go where they are needed. Adam Smith was the first first to see how a market economy allocates allocates resources and publicise it; and this process was what he meant by “the invisible hand”.

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The resulting output may be 100 kg p.a. of King Edward’s potatoes. If you add a 6th person output (but no more spades or land) output might increase to 180 kg – the new person can weed or water while the others dig, etc., so output will rise. The addition addition to total output output is then180-100 or 80 kg. This is themarginal product  of the sixth person. If you add a 7th person, output would still increase, perhaps to 250 kg – the addition to total output is 250-180 or 70 kg, which is the marginal product of the seventh person. You can see the 70 kg just added is less than the 80 kg added earlier - i.e., the addition to total output from last person employed is falling, which is to say that returns are diminishing. You might object that these figures are merely invented – which is true. But think! By the time you get to the 200th person, standing in your back garden and only five spades to work with, output is not going going to be large! It is probably zero, in that that there is no room to plant, dig or anything as your garden is wall-to-wall people! At some earlier   point, output must have reached a maximum then fallen to nothing. The point where output was at maximum might have been around the fifteenth or  twentieth person, and after after this, more people began to be a nuisance. nuisance. The new person might start to gossip and distract the others; or perhaps they trip over the new comer  now and then, so that output actually fell fell a little after he was employed. employed. When total output starts to fall, the marginal addition is negative, and total output starts to decrease at that point. This law must hold – we can always add enough labourers to completely fill your  garden, however large, and leave no room for for growing potatoes at all. The same applies to producing anything, for example, T-shirts. The table below shows a possible scenario.

SEEING THE LAW OF DIMINISHING RETURNS TO THE FACTOR OF PRODUCTION LABOUR 

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You should observe that in the above table: 1. As we add labour, total product increases. 2. Marginal product rises at first, then falls steadily after that, and finally it becomes negative. 3. When the marginal product is above the average product, average product is increasing; when marginal product is below the average product, average product is decreasing. This is the property of averages, it has nothing to do with economics! When the amount  added exceeds the average, it must pull the average up.

Let’s take an example of a Premier League soccer team week by week and see the average, total and marginal scores

Soccer Match: Average, Total, and Marginal Goals Scored

Match  Number  1 1 2 3 4 5

Goals scored in match 2 2 4 1 0 3

Total goals scored (adding col. 2) 3 2 6 7 7 10

Average goals  per match (col. 3 ÷ col. 1) 4 2.00 3.00 2.33 1.75 2.0

Marginal goals  per match (col. 2) 5 2 4 1 0 3

If you examine the table you will see that when the margin is above the average, it pulls the average up. And when the margin is below the the average, it starts to pull it down. It not only applies to a team scoring goals, or indeed any set of figures, it works just the same way in production. We can graph this too!

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The average product and the marginal product curves MP & AP

AP

MP 0

Quantity of the factor 

We can also draw a diagram of the total product curve.

The total product curve

Total Output

TP

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What sort of problems might might be encountered? They could be things like: like: •

We will start to run out of machinery (remember that we are only increasing labour, holding other factors constant) so that the relationship between the number of workers and the number number of machines gets worse. worse. In simple terms, the balance is wrong. In the example of your your garden, the workers ran out of  spades and had to find something else to do you will recall.



The emergence emergence of bottlenecks bottlenecks in the factory factory – storage space for materials, semifinished and finished products perhaps.



Possibly the workers workers cannot cannot find parking space nearby nearby,, which which annoys annoys them, them, and they then feel disgruntled and lower lower their efforts. This would not be the law of  diminishing returns as such, but a loss of motivation.

The production function

The production function shows how many of the factors of production we must use to get various different different levels of output. In other words, it shows the relationship relationship between different inputs and the resulting output. We can see production function in several ways: 1. We We can see it in the generalised form O = f (L, N, K) + R  (Which means “Output is related in some way to the inputs of land, labour, capital and the catch-all remainder term”). 2. We We can see it as the total product curve above. In the diagram, as we increase the use of labour, we we can watch total product increase. increase. This is a simple, one factor factor model. 3. We We can also see it as a box of choices, using two factors of production labour and

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2) A lot of labour and little capital.

Engineering information gives us the figures in the box that might look like:

The Box of Choices Capital (across) Labour (down) 1 worker 2 workers 3 workers 4 workers 5 workers

1 machine 9 20 26 33* 35

2 machines 18 27 33* 39 41

3 machines 26 33* 38 42 44

4 machines 33* 38 42 45 46

You can see that we can produce 33 units of output in several different ways – the firms will choose the cheapest method or the choice of technique to use, to maximise profits. If wages are low (relative to the cost of machines) the firm would use as more workers and fewer machines - four workers and one machine would do it (this is typical of a developing country like Indonesia). If wages are high (relative to the cost of machinery) machinery) the firm would choose to use more machines and few workers – in this case two machines and one worker (this is typical

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Marginal cost is the addition to total cost from producing the last unit of output [or one more unit – it is at the margin.]

Price, Costs

AC

0

MC

Output

 For all the theory of the firm, and all market conditions, the AC and MC curves look the same – you can always start by drawing the AC and MC CURVES  without even thinking!

Why are the shapes that way?

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AP & MP AC & MC

MP AP MC

0

AC

Output

Occasionally there might be a question in an exam asking about the relationship  between the two.

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4-6. THE DIFFERENT DIFFERENT POSSIBLE MARKET CONDITIONS CONDITIONS

The theory of the firm covers perfect competition, imperfect (or monopolistic) competition, and monopoly. These are increasingly less competitive in the order  listed. Oligopoly is considered to be something of a special case.

The Arrow of Competition:

Monopolistic competition Perfect Competition

Monopoly

Oligopoly

As just pointed out, all firm diagrams start the same way!

Price, Costs

AC

MC

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So what do we know? • • • •

The cost at the margin (the addition to total cost from the last unit produced) increases as production rises (the MC curve). The revenue from the last unit sold is the marginal revenue (MR). (MR). Logic tells us that the firm will continue expanding output and watching MC rise until it equals what the firm receives from the marginal unit sold (MR). Therefore when MC = MR it is the best the firm can do, so it stops there; it is in equilibrium.

We use the MC curve to trace what happens if a firm changes its output level, for that  very reason.

PERFECT COMPETITION COMPETITION (the right hand end of the arrow above)

Perfect competition is defined as a situation where there:



Are many many small buyers and sellers (firms) each too small to affect the price – the firms are "price-takers".



Is a homogeneous product [all are identical].



Is free entry and exit. This means that firm can join or leave the industry – it is both

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Equilibrium is where the marginal cost curve, MC, cuts the price line, P1. In perfect competition any of the tiny firms can sell more without having to lower its price – it is too small to affect price! This means that the price line above is the marginal revenue also. The firm always gets the same price at the margin. The price line line is also the average revenue revenue in perfect perfect competition. competition. It’s just the maths. maths. Total revenue = P x Q Average revenue = TR ÷ Q

Clearly if we multiply P by Q then divide the result by Q we must end up with P again!

Perfect competitors are price takers!

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And the small individual firms are price takers because they are too tiny to be able to change it - and there is no point selling it for less than they could get. If demand for the product increases in the industry, it causes an increase in price and firms move up the MC curve. Q. Why the MC curve? A. As was said above, because the firm is interested in increasing output as long as it  brings in a greater revenue than it costs to make the extra bit.

How an increase in demand in the industry affects the perfectly competitive firms:

We first change the price in the whole industry as demand has increased then trace this over to see what it would be like for an individual firm. The increased demand in the industry causes price to increase; each small firm enjoys this sudden increase in  price - and of course its profit increases. The firm then increases output in order to

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And the free entry and exit proviso means they can race in! And this means extra output, i.e., an increase in supply at the industry level, so price starts to fall back. This process bids away the profits all the way down to where we started where MC = MR = AC = P1. So in the long term, under perfect competition, no above normal  profits are possible. Q. Can you take the diagram above, draw it for yourself, then increase the supply curve until P2 falls back to P1? Try it now!

What happens if price falls below AC? At this level, all the firms lose money and continue to do so until some firms go out of business. When they do, supply decreases, so that price starts to increase, and this continues until the price is back to the original equilibrium position.

Average variable costs versus average total costs

Average variable costs must always be covered (they go directly into the particular 

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The advantages of perfect competition



Resources are allocated in the most efficient way to meet meet market demand and maximise consumer satisfaction. - This means that market mechanism works better.



It is the cheapest way of using the factors of production we have. - Which says that we are at the lowest part of the AC curve.



There is no cost of advertising, selling, marketing, or motions. These are often a form of waste to society as a whole, though beneficial for individual firms.



Rapid change is possible to meet new consumer demands – it is very flexible.



The interests of producers are the same as for consumers.



Freedom to choose exists.

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MONOPOLY – THE LEAST COMPETITIVE MARKET SITUATION (the left hand end of the arrow of competition)

Monopolistic competition Perfect Competition

Monopoly

Oligopoly

(There is some overlap between Unit 2 and Unit 4 on monopoly, so this may seem familiar to you.)

WHAT IS A MONOPOLY

Definition: Technically it is a sole supplier, i.e., i.e., there is one firm in the industry. industry. It is the industry.

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Marginal revenue and monopoly Marginal revenue is the addition to total revenue from the last unit sold. •

A perfectly competitive firm can sell as much as it wants at an unchanged  price. Its MR curve is equal to the price – every time it sells one more item it receives, say, an additional 50 pence, which adds 50 pence to TR. • A monopolist is the industry, so it faces a normal downward sloping demand curve.

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Price, Costs P

MC AC

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Problems with monopoly, “what is wrong with monopoly” or "the welfare effects of monopoly"



A monopoly limits output and keeps price high.



A monopoly redistributes income from all the consumers to this one firm or   person (an equity issue).



Monopolists may develop political and social social power over others, which reduces the efficiency of democracy and is inequitable. There are political dangers of a

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Benefits of monopoly – there are not many really, but some case can be made.



A monopolist can use monopoly profits for research and development, developmen t, leading to product improvement, faster growth, and lower costs, despite the argument above that they are inherently lazy. -

Joseph Schumpeter argued that they are important for innovation; he felt felt that big firms are the only ones that are able to afford the necessary laboratories, equipment and research staff.

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Where is the long-run equilibrium position?

At the tangent of the demand curve and the average cost curve, as in the diagram  below.

Price, Costs

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Price,

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Q. How far does it fall?

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Price, Costs

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society! We do not have allocative efficiency (where MC=MR) because the

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