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THE OBJECTIVES OF FIRMS

THE OBJECTIVES OF FIRMS

The Growth of FirmsFirms and Technological Change

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Lesson Objectives

• Understand that firms may grow in two ways – internal and external

• Appreciate the effect of technical progress on firms.

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Connector

• In pairs discuss two reasons why firms may choose not to pursue profit maximisation.

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Big Picture

• We will consider the growth of firms and how such growth might come about, allowing us to explore the costs and benefits of mergers and similar activities.

• and how firms are affected by technical change and innovation

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Big Picture• To arrive at the learning outcomes you will do the following:• Listen to teacher demonstrations on PPP• Draw graphs• watch VIDEO • ‘Stretch and challenge’ Questions• Group work• Independent work• Class discussion• Short presentation• Demonstration on the board• Pair marking• Advise on examiner’s tip

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Lesson Outcome

• Understand why and how firms grow in size

• Appreciate the effect of technological change upon firms

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Key Terms

• Horizontal integration ; • Vertical integration ; • Conglomerate merger ; • Lateral merger; • Invention; • Innovation; • Technical progress

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The Growth of Firms

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The growth of firms

• Increasing profit requires: • the reduction of costs, • which can be achieved by reaching the MES• and exploiting the economies of scale,

Or • increasing revenue by increasing market share• or obtaining a dominant position in the market.

• Both of these may occur as a result of a firm’s growth.

• Growth may occur in one of two ways – • Internal and external growth.

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Internal/organic growth

• Requires the use of profits or loans to finance expansion over a period of time by increasing the number of both fixed and variable factors within the firm.

• Innovation and creativity, which increase the customer base, are central to organic growth.

• Internal growth can occur in two ways:1. Extending an organisation’s geographical reach2. Expanding into new products in order to increase the

size of its available market.

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Internal/organic growth

POINTS FOR EVALUATION• Organic growth may be a fairly slow process

as the market may be saturated

• or the strength of the competition may mean the firm is unable to raise or even maintain prices.

• Lack of profit may also impede organic growth.

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External growth• This can be a rapid way for a firm to expand by acquisitions and

mergers.

• Firms merge amicably with other firms

• Or a hostile takeover may occur

• However, in a majority of cases mergers have failed to deliver the benefits that are expected and have not justified their costs.

• This is due to economies of scale in terms of ‘people issues’ such as:

– Cultural fit,– Leadership– Poor communication– The company’s ability to change.

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Four main types of mergers

1. Horizontal integration – two firms in the same stage of production combine their operations, e.g., two breweries combining.

2. Vertical integration – two firms at different stages in the supply chain come together.

– Vertical backward integration – a firm combines with a firm in the previous process, e.g., a brewery integrating with hop growers.

– Vertical forward integration – is combining with the next process, e.g., a brewery taking over public houses.

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Four main types of mergers

• A Conglomerate merger – firms have no obvious relationship but may decide to merge to increase their market size to satisfy managerial ambitions or diversify and reduce their risk exposure.

– E.g., brewery merges with shoe manufacturers.

• A Lateral merger – is a type of horizontal integration in that there are some similarities between the businesses.

– E.g., a brewery may merge with a restaurant chain to increase the market for its product.

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When considering external, as opposed to internal growth, companies may consider:• Time constraints – external expansion is more rapid

than internal growth.

• Costs – it may be cheaper to buy out another firm than to undertake new investment.

• The acquisition of a brand which is only available through external takeover.

• Asset stripping – the predator may be able to sell the firm’s assets for more than it paid for them.

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Activity – page 26

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Answers1. Organic growth occurs as a result of using ploughed-back

profits or loans to increase the numbers of factors of production in a firm; it is linked to innovation in terms of new products and new geographical areas. Apple were certainly innovators in terms of their MP3 technology (iPod) and have built a very strong customer base off the back of their innovation, allowing them to gain customers in other areas (iPhone and iMac).

2. Benefits of external growth include: high speed of growth, possibility for economies of scale to occur, cheaper to buy a firm than expand an existing firm, reduce competition, asset stripping.

3. Backwards vertical integration refers to one company taking over another company that is further back in the production process. Benefits include: more timely delivery of raw materials (which reduces costs), cheaper/better quality raw materials (which could reduce costs or improve the final product’s quality), higher profits from operating in a number of industries

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Firms and Technological Change

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Three components of technical progress

• More output can be produced with the same inputs• Existing output undergo an improvement in quality.• Completely new goods and services become

available.Technical progress enhances production and consumption possibilities by raising the productivity of capital – greater output can be obtained for the same inputs.

Technical progress allows us to do more with less and this improves the quality of life compared to previous generations.

Technical progress usually has to be embodied in new capital Equipment, new human skills or new intermediate products.

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There are two terms that need to be differentiated:

• Invention – coming up with a completely new idea or concept that can be patented.

• Innovation – the putting of an invention into commercial use, the process of converting knowledge and ideas into better ways of doing business or into new or improved products and services.– Innovation

• may lower costs • Come up with new products• New processes• New production techniques

} Dynamic EfficiencyWhich increases Economic growth

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The effects of innovation on the firm’s costs

• Figure 2.9 shows a firm using existing technology facing increasing returns to scale as the LRATC labelled ‘Old plant’ is downwards sloping.

• The firm is producing the output 0A at a unit cost of 0B.

• Now assume that some technological development lowers the costs curves of newly built plants and that the technology cannot be used by old plants because it must be embodied in new plants and equipment.

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The effects of innovation on the firm’s costs

• This is shown by the LRATC labelled ‘New plants’ where at the same level of output it shows a unit cost saving of BC.

• New plants will now be able to earn

profits and they will be built immediately.

• This will shift the industry’s supply curve to the right and prices will fall.

• Firms that have not invested in new plants will find it difficult to compete as their costs will be higher than firms that have exploited the innovation.

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Activity – page 27

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Answers

2. Invention refers to the generation of new ideas or concepts that can be legally protected using patents. Innovation refers to the transfer of an invention or idea to a new commercial product, or method of production. In industries where there is significant invention and innovation, firms compete with each other in terms of innovations in order to win market share and lower costs. This competition leads to shorter product life-cycles for the innovating companies, who often leave.

3. Innovation tends to lower costs, which feeds through into lower prices so we should expect consumer surplus to rise. However, some consumers feel that they have to have the ‘latest’ gadget or product, and will pay the often high price at which they are launched, which might actually reduce their consumer surplus – this depends on how much they would be willing to pay for a new product.

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The objectives of firmsInnocent’s objectives

Learning objectives: appreciate that in addition to profit maximisation, firms often have a range of other objectives that

they want to satisfy understand that firms can grow in different ways.Scenario• Innocent Drinks make smoothies, juices and ‘veg pots’, and are characterised by their ethical slant

on everything what they do. At just 10 years old, Innocent now has a total revenue of around £100m.

The Innocent ‘ethos’ is built around the four main principles advocated by its founders: ethical purchasing reducing/offsetting carbon emissions recycling charitable giving.These principles govern every decision made, from recruitment through to the purchasing of bananas

and advertising campaigns.Richard Reed, one of Innocent’s founders, has said that ultimately, Innocent’s objectives are to do with

growth and profit. Some might think that Innocent’s ethical stance would cause these objectives to suffer. However, many consumers buy Innocent products over the alternatives because of their inbuilt ethical approach, allowing them to feel like ‘do-gooders’. So, Innocent’s employees have to be both commercially minded, and altruistic – not an easy combination to find!

For the moment, Innocent’s founders are pursuing expansion in the European market, but are to work on global expansion when the time is right. As yet, there is no clear way forward; Adam Balon, one of the original founders, recently said that a sale of the company, a partial issue of publicly traded shares or simply continuing to grow organically were all options being considered. Achieving internal growth, however, is becoming more difficult as Innocent’s founders are having to delegate responsibilities, such as marketing and recruitment, that they have previously handled themselves.

Questions1. Explain what is meant by ‘total revenue’.2. Examine the importance of profit for companies.3. Using examples from the case study, and your own knowledge, outline other possible objectives

that a company such as Innocent Drinks might adopt.4. Outline reasons why achieving organic growth can be difficult for a company such as Innocent.5. Comment on the statement that ‘expansion via the sale of Innocent is the best way for the

company to grow’.

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AQA Examination-style questions, page 28.Data response question 1:

a) Marginal in economics refers to small increments. Many large companies would not be interested in the ‘marginal’ mines because it would incur significant cost to generate any revenue, that is, it would be small part of their overall profit. However, for a small company, such mines could generate enough profit.

b) Diagram should be similar to that shown in figure 09 from Chapter 2 of the student book. New technology would allow Petra to benefit from lower LRATC than De Beers; so, if costs are lower then profits are likely to be higher.

c) Define market share – relate it to De Beers previous strategy (that is, own as many diamond mines as possible). Explain why ‘higher returns’ (that is, higher profits) may be sought by De Beers (that is, profits provide funds for further investment, shareholders like high profits as it leads to higher dividends, reward for being entrepreneurial, etc.). Discuss advantages and disadvantages of two or three other objectives.

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Essay question 2:a) Reasons include: Reduces competition.

Strengths: less expensive to compete, higher brand loyalty. Weaknesses: could encourage investigation by Competition

Commission, could take advantage of market position and raise prices (thus reducing consumer surplus).

Control can be gained over companies further back/forward in the production process. Strengths: greater reliability of raw materials (delivery times,

quality, prices, etc.), reduce sources of raw materials for competitors.

Weaknesses: diseconomies of scale and miscommunication possible.

Leads to higher profits. Strengths: benefit from economies of scale thus reducing costs,

greater availability of funds for investment. Weaknesses: pay higher corporation tax, could take time for

increased market share to lead to higher profits.

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Essay question 2:b) Internal growth: Plough-back profit.

Issues to consider: reduced dividends for shareholders, depends on market interest rate (might be wiser to save), less risky than taking out a loan, small companies often have small profits so not much money available for investment in this way.

Borrow funds. Issues: costs of financing could be unmanageable if interest rates change, less

impact on shareholder dividends, easier for small businesses to borrow than use profits but often penalised with higher interest rates than larger, established companies.

Innovate/invent. Issues: not an easy or predictable thing to do, small companies may lack expertise

to take new ideas to market, can lead to rapid growth if the idea is good, leads to imitation.

External growth (mergers/acquisitions). Strengths: speedy, can be financially rewarding if there’s potential for asset

stripping, reduce competition, gain new brands without investing in marketing, can be cheaper than internal growth.

Weaknesses: could end up with diseconomies of scale, poor communication, poor culture fit between companies (especially if done very quickly), may be done for wrong reasons (satisfy egos of managers rather than for good business sense).