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 pharmaceutica
▪ Advertising – placing the product in the hands of celebrities or sponsoring sporting
or cultural events
▪ Branding – promoting the brand as being of certain quality (which may be
communicated through advertising), or imposing measures to improve brand
loyalty, such as loyalty cards
▪ Packaging – which may include free gifts, or competitions to win prizes
▪ After-care/customer service/warranties
▪ Product development
▪ Quality and innovation
▪ Mergers and acquisitions – these reduce the number of firms in the market and
therefore act as a way of removing competition from the market

→ The aim of non-pricing strategies is to shift the average revenue (demand) curve to the right
or to prevent it from falling as other firms try to increase their market share
→ The cost of advertising must fall below the increase in supernormal profits that comes from
shifting the average revenue curve
→ The effectiveness of non-pricing strategies may be questioned:
▪ It may be the case that other firms will also advertise or may copy the innovations
introduced (although this can be countered through effective – but expensive –
intellectual property protection)
▪ Spending large sums of money on an advertising campaign carries no guarantee of
success
▪ Non-pricing strategies may take a long time to work, and the firm may lack the
available fund or expertise to deploy these sorts of strategies
▪ Non-price strategies may not actually work, especially if rival firms counter with nonprice competition of their own

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1 Characteristics of perfect competition
→ There are a number of characteristics of perfect competition:
▪ Perfectly competitive markets have many small firms
▪ They tend to produce homogenous pro
group together to act as a sole buyer, giving them the ability to force suppliers to lower
prices
→ It is important to note that households can act as suppliers of labour, and so where
employment in a sector is dominated by one firm, as with the NHS dominating UK
healthcare employment, that firm can set wages
→ Monopsony power may help to balance out monopoly power, creating a bilateral monopoly
→ For example, some wine-producing regions with special protections can use these
protections to raise prices for their region, but supermarkets can group together to counter
this power, creating a balanced price for consumers

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8 Contestability
→ A contestable market exists where there are low sunk costs and therefore low barriers to
entry and exit
→ It is therefore theoretically possible for new firms to enter the market and compete with the
incumbent firm/firms
→ There does not necessarily have to be a large number of firms in order for a market to be
contestable
→ This may be the case where there is no dominant firm; as a result, new firms do not have to
spend much on advertising/branding, and it is therefore possible to quickly enter an industry
where they see supernormal profits being made
→ A range of industries can be said to be contestable; of most significance, the airline industry
saw the advent of low-cost airlines such as Ryanair and Easyjet, who were able to lease
aeroplanes and use smaller, regional airports in order to enter the market with low barriers
→ Signs of a high level of contestability are:
▪ Low fixed costs, e
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low levels of high-tech machinery required
▪ Low sunk costs, e
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minimal advertising on a national scale
▪ Weak brand names/very few patents
▪ Low potential profitability in the long-run
→ The signs of an uncontestable market are the reverse of the above, but you might also
observe the following:
▪ Strong oligopoly or market power of incumbent firms, e
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limit pricing might be
used to keep out possible entrants
▪ High levels of non-price competition, e
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firms are trying to raise barriers to entry by
increasing brand loyalty, perhaps by endorsing a sporting competition
▪ Investigations by the CMA – although the competition authorities might not take
many actions against some industries, the frequency of their investigation can imply
that other firms have found it difficult to compete, e
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the energy markets

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4 Price regulation
→ Price capping is often used to regulate several privatised industries in the UK
→ The price cap is an upper limit set on the amount by which firms can increase their retail
prices
→ It takes into account the level of inflation measured by the Retail Price Index (RPI), and then
takes account for any possible efficiency gains or investment
→ The advantage of price capping is that it allows a firm to keep any profit it makes through
bringing about greater efficiency gains that the regulator has calculated as reasonable
→ In addition, because the X and K factors are usually in place across a lengthy period – around
five years – firms are able to plan ahead and know that they will not be penalised for further
efficiency savings
→ However, if the regulator underestimates the efficiency gains a firm can be expected to
make then the firm can make large supernormal profits
→ The tendency for this to occur has led to claims of regulatory capture, with the regulator
being less strict on firms under its control
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1 RPI + K
→ This takes the RPI and allows for the K factor, which account for the additional capital
spending that the regulator and the firm have agreed is necessary
→ For example, a water board needs to spend on capital in order to maintain water
infrastructure, and they will agree this amount of spending with the regulator and can pass
this cost onto the consumer
→ A similar process is used by train companies

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2 RPI – X
→ This take the RPI and subtracts a factor X determined by the regulator
→ X represents the efficiency gains that the regulator has determined can reasonably be
achieved by the firm in question
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6 Performance standards and quality targets
→ The regulator can also set performance targets that it will then monitor
→ These may be based upon improvements in the quality of a service or reductions in the
number of customer complaints
→ This may be supplemented by a system of fines, should the firm fail to meet the
performance targets, or rewards, should the firm meet them
→ This has been used by the regulator to monitor the punctuality of trains in the UK and so
helps determine price increases
→ Penalties can be attached to the targets so that consumers derive the benefit if customer
service falls below a minimum standard
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