Notesale: Turn your study into money

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3 Business behaviour and the labour market
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1 Reasons why some firms tend to grow
→ Increase market share – to hopefully become the dominant firm in a particular industry,
allowing them to move beyond perfect competition and obtain supernormal profit in the
long-run
→ Increase sales – through larger brand recognition and more sales outlets, either in the same
country, or even allowing a firm to gain a holding in a foreign market
→ Increase economies of scale – the firm’s increased size allows it to lower long-run average
cost (LRAC), moving closer to productive efficiency
→ Gain power – to prevent takeover by larger predatory businesses and withstand shocks such
as the 2009 Financial Crisis
→ Satisfy managerial ambitions – some managers will seek to expand in order to improve
confidence in the business, which may cause share prices to rise, especially where managers
are paid – in part – with shares, and it also allows them to leave a legacy behind
→ Make the most of an opportunity – some firms will have revenues that they do not wish to
class as ‘profit’, upon which they will pay corporation tax, so they will instead use them to
acquire another business or expand their own
→ Gain expertise – some firms may wish to expand into a new industry, and rather than trying
to establish themselves in this sector slowly, they can instead buy a ready-made business
that has a history of making profit
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3 Significance of the divorce of ownership from control: the principal-agent problem
→ In cases where there are a large number of shareholders, it becomes impractical for all
shareholders to have a say in the day-to-day running of the business
→ As a result, they delegate this task to a board of directors, who in turn delegate work to their
managers – this chain is known as the ‘divorce of ownership’
→ The ‘divorce of ownership’ has one main issue, referred to as the ‘principal-agent problem’,
the ‘principal’ being the owner of the business, and the ‘agent’ being the manager of the
business
→ The ‘divorce of ownership’ means that the business may not be managed by the agent in the
way that the principal wishes, and in such examples asymmetric information exists where

the agents know their behaviour yet principals do not necessarily, and principals know their
objectives, but agents do not necessarily
→ The ‘principal-agent problem’ may lead to dismissals, such as Antony Jenkins’ dismissal from
Barclays Bank in 2015, when he was not able or willing to cut costs, and therefore did not
increase profits as much as the directors wished
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1 How businesses grow
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1 Organic growth
→ Firms can grow by expanding the scale of their operations, thus increasing market share
→ This is known as internal or organic growth, and is achieved by investment from the firm
within the firm
→ It is paid for either by ploughing back profits within the firm or by borrowing (through taking
out loans, selling shares, or issuing bonds)
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1 Horizontal mergers
→ This is a merger between two firms at the same stage of production
→ Examples include the merger of the banks TSB and Banco Sabadell in 2015, or the proposed
merger between phone providers O2 and Three, which was blocked by the Competition and
Markets Authority (CMA) in 2015
→ The advantages of horizontal mergers to firms is that they may increase their market share,
benefit from economies of scale, and face reduced competition
→ The disadvantages of horizontal mergers to firms is that they may face unknown costs, and
more importantly their brand may be diluted or weakened
→ The advantages of horizontal mergers to employees or other stakeholders is that there may
be some opportunities for promotion, and the firm’s prestige may improve
→ The disadvantages of horizontal mergers to employees or other stakeholders is that those
who are duplicating work or are unable to move to new headquarters may lose their jobs
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3 Backward vertical mergers
→ This is when a firm merges with a firm closer to the suppliers in a production process
→ For example, in 2008 Petronas, a state-owned Malaysian petroleum company, bought Star
Energy plc, a British oil exploration firm
→ The advantage to firms is that backward vertical mergers assures supplies in timing and
quality, leading to reduced costs of supply for firms
→ However, the firm may lack expertise in the new industry, and may lead to over-exposure to
the end-product in one market; if demand for that one good falls then that firm is at very
high risk

→ The advantage to employees and other stakeholders are that expertise and opportunities for
promotion are widened, they experience increased market presence, and profitability may
lead to increased share prices in the long-run
→ However, the initial costs of integration may damage profitability and therefore negatively
impact the share price in the short-run
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5 Vertical demergers
→ This is where firms at different stages of the production process are broken up
→ In 2015, eBay, an online auction site, demerged PayPal, a payment system, and listed its
shares separately
→ This approach avoids negative attention from competition authorities, and decreases
exposure to risk in the market as a whole
→ However, any economies of scale cost savings are lost, and there are sunk costs in goodwill
(the reputation of a business), branding and human capital
→ Vertical demergers allow employees and stakeholders to focus on the core product,
providing scope for specialisation and increased returns to investors
→ Nevertheless, it narrows expertise and reduces opportunities for promotion
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2 Constraints on business growth
→ Barriers to entry into or exit from an industry are obstacles that ensure the continued
monopoly power of firms in a market

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1 Regulation
→ The government itself may prevent the entry or growth of a firm
→ Acts of Parliament can allow monopolies to be formed and protected, such as the provision
of the National Lottery, and the former nationalised utilities – water, rail and electricity – all
enjoyed government protection of their monopolies
→ Patents also give firms legal protections to ensure that ideas or processes are protected
from competition throughout the life of the patent
→ This is important in innovation-heavy industries such as pharmaceuticals, where
considerable money is invested in research and development and this innovation can only
be rewarded financially over time
→ Firms require licences or specific qualifications in order to enter a certain industry, so for
example law and accountancy firms have to be approved by their respective trade bodies,
and radio stations have to obtain a licence before they can broadcast
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2 Marketing barriers
→ Marketing barriers are imposed by businesses currently operating in an industry
→ This could be through branding or through a new advertising campaign to establish brand
recognition
→ This investment in marketing cannot be recouped if the campaign fails – this is known as
sunk costs
→ For example, Coca-Cola spent millions in trying to bring its purified tap water Dasani to the
UK market, but after negative publicity the product failed to take off and Coca-Cola
abandoned its plans
→ Most companies do not have the capacity to take such a risk, and so these market barriers,
caused by the size of sunk costs, can prevent a business growing into a new industry or
moving its operations overseas
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3 Pricing barriers
→ Firms already in the market may try to prevent new firms entering in two very distinct ways,
predatory pricing and limit pricing
→ This is explored in more detail in section 3
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If this occurs then
supply will increase vastly, causing prices and revenues to fall, meaning that any potential
profits will be eroded
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5 Size of the market
→ If a firm serves a niche market that will not support expansion then there is little scope for
growth
→ Manufacturers of cricket bats or a local grocery store may have expanded as far as their
market will allow

→ In some cases the firm may hold a local monopoly, and any further expansion will put this at
risk
→ Some small firms may survive on the basis that they are able to produce a personal service;
if they grow then they may lose some of their loyal customers and revenues may fall
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6 Lack of resources and access to finances
→ The owner of the firm may lack the knowledge, expertise or funds needed for expansion
→ As the firm expands as employs more people it may encounter increased bureaucracy, such
as needing to complete National Insurance returns or having to comply with greater financial
regulations
→ Either of these will add to the firms costs or may be beyond the managers’ level of expertise,
and so this acts as a barrier to expansion
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7 Minimum efficient scale
→ In some cases a firm may have already exploited economies of scale and be operating at the
most productively efficient point
→ Optimum efficiency may have already been achieved and so any further growth would lead
to diseconomies of scale and inefficiencies
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8 Owner objectives
→ Expansion may lead to increased rewards but it may carry an opportunity cost in terms of
lost leisure
→ In the case of a sole trader, such as an artisan spoon whittler, they may derive pleasure from
their work, and by scaling up production and becoming removed from the production
process, they may lose this utility
→ They therefore lack the motivation to expand; this is an example of satisficing
→ This is where firms make enough profit to stay in business and then allows other motives,
such as personal pleasure, to take precedence
→ Some managers are risk-averse, and will not be willing to face the potential negative
consequences of expanding a business – this may be a result of behavioural economic
phenomena, or it may simply be a wish to insulate family finances, a mortgage or personal
savings against risk
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9 Avoiding attention from potential buyers
→ The growth of the firm and its increased profits may result in unwanted overtures from
larger firms wishing to buy out the sole trader
→ It may therefore be advantageous to sole traders and small firms who want to retain control
of their own production to remain small; this allows them to avoid attention
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10 Tax thresholds and other benefits of remaining small
→ Small firms are able to access additional training grants and government finance schemes,
and they may also receive tax benefits
▪ After 2002, firms with profits of less that £10,000 were not liable to pay any
corporation tax, although this was reversed in 2006
▪ Firms with turnover of less than £85,000 are not liable for VAT in the UK, starting
from April 2018
→ Since 2009, the government has supported small firms with a turnover of up to £41 million
through the Enterprise Finance Guarantee, which allows smaller firms to access bank loans

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1 Reasons for demergers
→ Some firms may grow too large and experience diseconomies of scale
→ As a result of the growth of output, the business and managers may lose focus and control
over day-to-day management of the firm, leading to an increase in long-run average costs
→ In order to avoid this, a firm may chose to break up or demerge
→ This may create a number of smaller firms, all able to concentrate on their specialist areas
and maximise their own economies of scale, and, with that, the profits available for
shareholders
→ However, as a result, some parts of the business may be shut leading to a loss of jobs
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2 REVENUES, COSTS AND PROFITS
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1 Revenue
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2 Average revenue
→ Average revenue (AR), or revenue per unit, is how much people pay per unit (price) and also
the demand curve
→ 𝐴𝑅 =

𝑡𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒
𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦

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4 Price elasticity of demand and its relationship to revenue concepts
→ If we consider the elasticity of two
points on the average revenue
curve, we can see that the elasticity
changes at different points along
the curve
→ In the diagram to the right, we can
demonstrate this point
→ Moving from point A to point B
involves a fall in price of 25%, and
an increase in quantity of 50%
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3%, and
an increase in quantity by the same
amount, with a PEd of -1
→ The top half of the demand curve, where the elasticity is -2, is relatively price elastic, and the
bottom half of the demand curve, with an elasticity of -1, is relatively price inelastic
→ We can apply this theory to understand what happens to total revenue as quantity
increases; an fall in price with price elastic demand leads to greater revenue, and a fall in
price with price inelastic demand leads to reduced revenue
→ The maximum total revenue is located at the quantity at which the price elasticity of
demand for a good is unitary

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2 Costs
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2 Total cost
→ There are two types of cost: fixed costs and variable costs
→ Fixed costs – these costs do not change with output
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In the future, the supermarket will be able to buy more land adjacent to the site,
showing that in the long-run, all factors of production are available
→ Fixed costs may be referred to as overheads
→ Variable costs – these costs do change with output and can occur in both the short-run and
the long-run
→ An example may be a firm’s raw material costs, which increase as the firm produces more
products
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3 Average costs
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1 Average fixed cost
→ Average fixed cost (AFC) is calculated as follows:

𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
𝑜𝑢𝑡𝑝𝑢𝑡

→ For example, if a firm’s fixed costs are £1,000 and output is 100, AFC is calculated at £10 per
unit of output
→ As output increases, AFC will alw
and the risks it can take
→ Although several major UK banks were partially nationalised, those that were not (such as
Barclays) are still subject to new, tougher regulations
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2 Controls from outside the UK
→ Direct controls form the EU take precedence over UK rules – for the time being
→ For example, limits of carbon emissions or employment rules were set by the EU and cannot
be defied by the UK government
→ Decisions by other bodies, such as the World Trade Organisation (WTO) will tend to override
business decisions in the UK

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3 Government intervention to promote contestability
→ Governments all around the world attempt to promote contestability in markets in order to
give consumers greater choice, and to promote innovation and competition
→ A perfectly contestable market will in theory have no barriers to entry, and will have no
restrictive practices – this is what the government tries to curtail

→ Incumbent firms will often use their position, perhaps in the form of pricing strategies or
legal barriers – patents or access to a particular technology – to ensure the market does not
become contestable
→ Regulators will consider whether the behaviour of the incumbent restricts freedom of entry,
and the regulators may then intervene to open up markets
→ In addition, the government will seek to promote start-up businesses as these firms are able
to establish themselves as challengers to the incumbent operator, especially if they can
target a specific sector of the market that has not previously been explored, as with Easyjet
and Ryanair’s emphasis on budget travel

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4 Privatisation, competitive tendering and deregulation
→ Privatisation is the process by which the government transfers the ownership of a stateowned enterprise from the public sector to the private sector
→ For example, the recent sale of Royal Mail into the private sector is an example of
privatisation
→ With shareholders to satisfy, the newly privatised firm will seek to maximise profits and will
therefore seek to increase sales and reduce costs through greater efficiency
→ When it is possible, these firms will be allowed to compete with other firms, such as in the
telecommunications industry, where consumers have a choice between BT, the formerly
nationalised service, and a range of other telecoms providers
→ Some activities that were previously provided by the government are now provided by
private firms in jobs which have been tendered out; i
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the transit of prisoners, hospital
catering and cleaning
→ The process through which such contracts are arranged is known as competitive tendering,
which results in the most competitive and cost-effective bid winning – however, firms may
seek to lower costs in order to win the tender, and quality may therefore suffer
→ Certain markets, such as the bus sector, have been opened to competition through the
deregulation of the market, so that any firm – within reason – can set up and begin to
compete for customers

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5 Government intervention to protect suppliers and employees
→ The government will intervene in the ways described through the CMA as well as through
the creation of legislation and the avoidance of monopolies and monopsonies
→ This helps to protect suppliers who would otherwise have been the victims of monopsony
power which could force them to reduce their prices and face reduced welfare
→ Firms who the CMA deems to be acting anti-competitively can be fined – although this
hardly seems fair compensation for the suppliers who may have gone bankrupt in the
interim

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6 Impact of government intervention
→ As already discussed, the government, through the regulator, can help to break up and fine
firms
→ It can also block mergers and jail executives who support anti-competitive practices
→ In these instances, the government will hope to increase competition and reduce prices,
increasing consumer welfare, and improving quality and innovation
→ Sometimes a firm may be prevented from merging with another firm because it will be seen
to reduce competition, despite the fact that the firm may cease trading and pass the
shutdown point if it cannot merge

→ Increasingly, local regulators play only a small part in deciding the fate of firms, as
international regulators take on increasing importance
→ This is led largely by an increase in globalisation and the growing interconnectedness of
markets
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