A2 Micro Business Economics

A2 Microeconomics
Business Economics
Study Companion
GEOFF RILEY
10th
Edition - 2013

© Tutor2u Limited 2013 2
A2 Microeconomics Study Companion – 2013
I gratefully acknowledge the help given in the preparation of this study companion by my own students and I
also acknowledge some of the ideas and arguments put forward in articles written by Bob Nutter, Tom White,
Penny Brooks, Mark Seccombe, Mo Tanweer, Jim Riley, David Carpenter, Ben White, Liz Veal, Ruth Tarrant,
Ben Cahill, Ben Christopher and Mark Johnston
Table of Contents
1. Objectives of Businesses and the Growth of Firms ...............................................................................3
2. The Growth of Firms.............................................................................................................................7
3. Calculating the Revenue of a Firm ......................................................................................................16
4. Calculating a Firm’s Costs..................................................................................................................18
5. Production in the Short and the Long Run...........................................................................................24
6. Long Run Costs: Economies of Scale.................................................................................................27
7. Diseconomies of Scale .......................................................................................................................37
8. Profits.................................................................................................................................................39
9. Divorce between Ownership and Control ............................................................................................47
10. Measuring Market Concentration ........................................................................................................49
11. Barriers to Entry and Exit in Markets...................................................................................................52
12. Technological Change, Costs and Supply in the Long-run ..................................................................56
13. Perfect Competition – Economics of Competitive Markets...................................................................60
14. Monopolistic Competition....................................................................................................................67
15. Model of Pure Monopoly.....................................................................................................................69
16. Monopoly and Price Discrimination in Markets....................................................................................71
17. Monopoly and Economic Efficiency.....................................................................................................76
18. Oligopoly – Non Collusive Behaviour ..................................................................................................85
19. Oligopoly – Collusion between Businesses.........................................................................................92
20. Oligopoly - Game Theory....................................................................................................................96
21. Contestable Markets...........................................................................................................................99
22. Monopsony Power in Product Markets..............................................................................................105
23. Consumer and Producer Surplus......................................................................................................110
24. Summary on Market Structures ........................................................................................................113
25. Government Intervention – Competition Policy..................................................................................116
26. Government Intervention – Price Regulation.....................................................................................122
27. Government Intervention - Privatisation and Nationalisation..............................................................128
28. The Private Finance Initiative (PFI) ...................................................................................................134
29. Industry in Focus - Water..................................................................................................................137
30. Business Economics Glossary..........................................................................................................140

1. Objectives of Businesses and the Growth of Firms
Businesses supply goods and services to markets:
 Private sector businesses seek to make a commercial rate of return for the capital invested by their
shareholders. Examples of private sector businesses include the retailer Tesco the express parcel
and logistics operator FedEx, the bank Santander and the electronics corporation Samsung.
 Public sector businesses are wholly or part-state owned. Examples of public sector firms include
Network Rail, East Coast Trains and the Royal Mail.
The usual theory of the firm assumes that businesses have sufficient information, market power and
motivation to set prices for their products that maximise their total profits
 This assumption is criticised by economists who have studied the organisation and objectives of
modern-day corporations both large and small. Businesses have a much wider range of objectives
 Not only do most businesses frequently move away from pure profit-seeking behaviour, many are
deliberately organised and operate in a way where profit is not the only objective.
Examples of different business objectives
There will always be a range of business objectives. An increasing number of companies are refocusing their
priorities beyond profit and towards the welfare of their suppliers, employees and the planet.
1. Profit maximisation (this occurs where marginal revenue = marginal cost)
2. Revenue maximisation (this occurs where marginal revenue = zero)
3. Increasing and protecting market share
4. Breaking into a new market and making sufficient profit to remain there in the long run
5. Surviving a recession and/or a persistently slow recovery
6. Pursuing ethical business objectives (e.g. promoting corporate social responsibility)
7. Providing a public service – see later sections on nationalised (state-owned) industries
Why might a business depart from profit maximisation?
Some explanations relate to the lack of accurate information required to set profit maximising prices. Others
concentrate on the alternative objectives of businesses.
 Imperfect information:
o It might be hard for a business to pinpoint their profit maximising output, as they cannot
accurately calculate marginal revenue & cost
o Day-to-day pricing decisions are taken on the basis of “estimated demand” or “rules of
thumb”. Businesses can take advantage of their market experience when setting prices
o A business might look to add a profit margin on top of average cost – “cost-plus pricing”.
 Multi-product businesses:
o Most businesses are multi-product firms operating in a range of markets across countries
and continents – the volume of information that they have to handle can be vast. And they
must keep track of the ever-changing preferences of consumers.
o The idea that there is a neat, single profit maximising price is redundant

Maximisers and Satisficers
Maximisers behave in a traditional
economic way and always try to make the
best possible choice from the available
alternatives.
Satisficers examine only a limited set of
alternatives, and choose the best between
them
Source: Professor Paul Ormerod
Behavioural Theories of the Firm
Behavioural economists believe that large businesses are
complex organizations made up of different stakeholders – i.e.
groups made up of different people who each have a vested
interest in the activity of a business. Examples include:
o Managers employed by a business and other employees
o Shareholders – people who have a stake in a business
o Customers
o The government and it’s agencies
Each group is likely to have different objectives or goals at points
in time. The dominant group at any moment can give greater
emphasis to their own objectives – for example price and output
decisions may be taken at a local level by managers – with
shareholders taking only a distant view of the company’s
performance and strategy.
If firms are likely to move away from pure profit maximising
behaviour, what are the alternatives?
1. Satisficing behaviour is when businesses move away
from pure profit maximisation and choose instead to aim
for minimum acceptable levels of achievement in terms
of revenue and profit. Satisficing is when someone only
considers a limited number of alternatives
2. Sales Revenue Maximisation
 The objective of maximising sales revenue rather than profits was developed by William Baumol
whose work focused on the behaviour of manager-controlled businesses
 Baumol argued that annual salaries and perks are linked to sales revenue rather than profits
 Companies geared towards maximising revenue are likely to make extensive use of price
discrimination to extract extra revenue and profit from consumers. A firm might also aim to
maximise sales revenue rather than profits because it wishes to deter the entry of new firms
 If a firm decides to aim to maximise sales revenue rather than profits, one of the consequences
might be a reduction in the price of the firm’s shares
3. Managerial Satisfaction model
An alternative view was put forward by Oliver Williamson (1981), who developed the concept of managerial
satisfaction (or managerial utility)
 Assuming that the firm’s costs remain the same, a firm will choose a lower price and supply a higher
output when sales revenue maximisation is the main objective
 In the following diagram, the normal profit maximising price is P1 at output Q1 and the revenue
maximising price is P2 at output Q2
 Consumer surplus is higher with sales revenue maximisation because output is higher and price is
lower. Producer surplus is greater when profits are maximised

Edinburgh Bicycle Co-operative operates across eight
stores in Scotland and England as well as online and
has around 100 workers, each with an equal share in
the business
Diagram to show different objectives and different price and output combinations
Social Entrepreneurs / Social Enterprises
 A social business or a social enterprise is a business created to address a social problem or issue
that only makes enough profit to sustain itself
 Profits are reinvested for one or more social purposes in the community, rather than being driven by
the need to seek profit to satisfy investors
 Social entrepreneurs are looking to achieve social, cultural and environmental aims
 In the summer of 2013, research published found that there are currently 70,000 social enterprises in
the UK contributing £18.5bn to the economy and employing almost 1m people. They include Jamie
Oliver’s Fifteen restaurant chain and The Big Issue magazine sold by homeless people
Co-operative Businesses
 Co-operative businesses (Co-ops) are owned
and run by their members, who can be
customers, employees or groups of
businesses.
 The supermarkets-to-funerals Co-op Group is
the biggest, followed by John Lewis
Partnership, the retailer. Farmers’ co-ops are
also popular in the UK.
 Other co-ops include community pubs,
supporter-run football clubs and foster care
and childcare providers
 These types of business are founded and run
on principles of shared ownership, shared
voice and shared profits.
Costs
Output (Q)
AC
AR (Demand)
MR
MC
Q1
P1
AC1
Profit Maximized at Price P1
P2
AC2
Q2
Revenue Maximized at Price P2

Not for Profit Businesses
These are charities, community organisations that are run on
commercial lines e.g. Network Rail:
o Network Rail: Their stated purpose is to deliver a safe,
reliable and efficient railway for Britain
o It is a company limited by guarantee – whose debts are
secured by the government
o Network Rail operates as a commercial business and
regulated by the Office of Rail Regulation
o Network Rail is a "not-for-dividend" company - profits are
invested in the railway network.
o Train operating companies (TOCs) pay Network Rail for use
of the rail infrastructure
o They are given targets for punctuality and safety
Ethical Businesses – Corporate Social Responsibility
Corporate social responsibility happens when companies
integrate social and environmental concerns in their business
operations and in their interaction with their stakeholders on a
voluntary basis
Key reasons why firms are increasingly embracing CSR
 Altruism – being a good citizen
 Window-dressing to appease stakeholders
 Contracting benefits – e.g. helps recruit, motivate and
retain employees
 Customer-related motivation: attract customers; brand
positioning
 Lower production costs (packaging, energy usage)
 Risk management – address potential legal or
regulatory action
 Improved access to capital – for example, the rise
ethical investment funds looking to make equity
investments in companies with strong CSR reputations
Michael Porter - Shared Value and
the Limitations of CSR
Narrow views about how to create profit
has created disconnect between
businesses and society and needs to
change according to Harvard Business
School Professor Michael Porter.
“A growing number of companies known
for their hard-nosed approach to
business—such as GE, Google, IBM, Intel,
Johnson & Johnson, Nestlé, Unilever, and
Wal-Mart—have already embarked on
efforts to create shared value by looking
again at the intersection between
society and corporate performance.”
Shared value is creating economic value
by creating social value
In recent times, creating value has
tended to focus on short-termist thinking
- Businesses have been long on driving
huge sales and output volumes, downsize
and de-layering inefficient management
and generally responding to pressure
from financial markets to deliver
immediate results through cost-cutting,
dynamic pricing and increasingly tough
marketing that can often persuade
people to buy things that are not good
for them.
This involves a recalibration and a
rethinking about what a product really
is and what needs a business is meeting,
for example in the food industry,
products that are nutritious and healthy
rather than focus on volume, lower unit
costs and higher profits. He notes to
increasing prominence of social
entrepreneurs with revenue generating
business models.
Consumers looking at the world
differently and expressing their
preferences in strong ways - this is
already having a direct effect on
supermarket behaviour.

2. The Growth of Firms
Why do firms grow?
1. Profit motive:
a. Businesses grow to achieve higher profits and raise returns for their shareholders
b. The stock market valuation of a firm is influenced by expectations of future sales and
profit streams so if a company achieves disappointing growth figures, this might be reflected
in a fall in the share price. This then opens up the risk of a hostile take-over and makes it
more expensive for a quoted company to raise fresh capital by issuing new shares
2. Cost motive:
a. Economies of scale have the effect of increasing the productive capacity of the business
leading to lower long run average costs. They help to raise profit margins at a given price
3. Market power motive:
a. Firms may wish to increase market dominance giving them increased pricing power
b. This market power can be used as a barrier to the entry of new businesses
c. Larger businesses can build and take advantage of buying power (monopsony)
4. Risk motive:
a. Growth might be motivated by a desire to diversify production and/or sales so that falling
sales in one market might be compensated by stronger demand in another sector
b. This is known as achieving economies of scope and is a feature of conglomerates
5. Managerial motives: Behavioural theories of the firm predict that business expansion might be
accelerated by senior managers whose objectives are different from the major shareholders.
How do firms grow?
Organic Growth
Organic growth is also known as internal growth. It happens when a business expands its own operations
rather than relying on takeovers and mergers. Organic growth might come about from:
 Increasing existing production capacity through investment in new capital & technology
 Development & launch of new products
 Finding new markets for example by exporting into emerging countries
 Growing a customer base through marketing

External Growth
External growth takes place through mergers or take-overs.
There are many potential advantages:
 Faster speed of access to new product or market areas
 Increase market share / increased market power
 Access economies of scale (perhaps by combining
production capacity)
 Secure better distribution channels / control of supplies
 Acquire intangible assets (brands, patents, trademarks)
 Overcome barriers to entry to target markets
 Defend a business against a takeover threat
 Enter new segments of existing market
 To take advantage of deregulation in an industry
Horizontal integration: When two businesses in the same
industry at the same stage of production become one – for
example a merger between two car manufacturers or drinks
suppliers. Recent examples of horizontal integration include:
 Cadbury buying Innocent Smoothies
 Cadbury was bought by the American Kraft Foods
in 2010. It was then spun off into Mondelez
International - Kraft Group's international snack
and confectionary business
 Lloyds Banking Group taking over HBOS
 Tata buying Jaguar Land Rover from Ford Motors
 Iberia and BA merger
 Costa Coffee (Whitbread) buying Coffee Nation
 Volkswagen buying Porsche
 Arla, the Swedish-Danish dairy co-operative
merged with British co-op Milk Link in 2012
 Two car manufacturers (e.g. Daimler & Chrysler)
 Two tour operators (e.g. TUI & First Choice)
 Asda buying Netto (food supermarkets)
 Amazon buying LoveFilm
 Virgin Money buying Northern Rock
The advantages of horizontal integration include the following:
1. It increases the size of the business and allows for more
internal economies of scale – lower long run average
costs – improved profits and competitiveness
2. One large firm may need fewer workers, managers and
premises than two – a process known as rationalization
again designed to achieve cost savings
3. Mergers often justified by the existence of “synergies”
Examples of Organic Growth
Poundland
Poundland was formed in 2000 and
has grown strongly due to a focus
on a constantly rotating product
range sold at a single price point.
Ten years after starting-up,
Poundland was sold to a US venture
capital firm for £200 million, when
its revenues had grown from
nothing to over £400m per year.
The organic strategies was to open
new stores in suitable locations and
repeat the formula of offering
heavily discounted products to a
mainly female customer base.
Poundland’s profits grow 26.5% in
the year to April 2012. It will open
60 new stores in 2012
BSkyB
In 2004, BSkyB set a long-term
objective of growing its household
subscriber base to 10 million
households/customers. The strategy
was to grow organically by focusing
on investment in content and
innovation.
2003: Revenue £3.2bn Profit £128m
2010: Revenue £5.9bn Profit
£1,173m
Subway
Subway is an American restaurant
franchise that mainly sells
submarine sandwiches (subs) and
salads. In 2001, Subway had just 52
franchised outlets in the UK, a tiny
number compared with its 14,800
around the world in 2001 As of
April, 2011, Subway operates
34,501 stores in 98 countries and
territories. There are currently
1,500 Subway franchises in the UK
and the company has recently
announced a new objective to grow
that to 3,000 outlets in the next
three years

Vertical Integration for a UK Chocolate
Retailer
Hotel Chocolat is a British cocoa grower and
chocolatier and undoubtedly one of the big
retail success stories in recent years. The
business has annual sales exceeding £70
million a study from Bain and Company
published in Marketing week recently placed
Hotel Chocolat as the 4th most consumer
advocated brand in the world, and the only
UK brand to appear in the top ten.
Hotel Chocolat is a vertically integrated
business that owns and operates cocoa
plantations in St Lucia (the Rabot Estate
pictured above) and which roasts and
manufactures chocolate in Cambridgeshire.
The business started with producing
peppermints for the corporate market and
Hotel Chocolat was one of the early adopters
of online e-retailing in the UK in the early
1990s. Digital channels have proved effective
throughout the growth story and sales from
the web site now account for around forty per
cent of the total.
4. Creates a wider range of products - (diversification). Opportunities for economies of scope
5. Reduces competition by removing rivals – increases market share and pricing power
Vertical integration:
Vertical Integration involves acquiring a business in the same
industry but at different stages of the supply chain. The
supply chain is the process by which production and
distribution gets products to the customer.
1. Forward vertical: Closer to the final consumers of
the product e.g. a manufacturer buying a retailer
2. Backward vertical: Closer to raw materials in the
supply chain e.g. a steel firm buying a coal mine
Examples of vertical integration might include the following:
 Film distributors owning cinemas and digital
streaming platforms
 Brewers owning/operating pubs (forward
vertical) or buying hop farms (backward
vertical)
 Crude oil exploration all the way through to
refined product sale
 Record labels and music stations
 Drinks manufacturers integrating with bottling
plants
 Hewlett Packard purchasing Autonomy, a UK
based software firm (Aug 2011)
 Google - a software business - buying
Motorola, a phone maker
 Publishing group Pearson paid more than
£500m for Grupo Multi - Brazil’s largest
private network of English language schools
(December 2013)
 Technology companies growing vertically through hardware, software and services
Examples of recent acquisitions in the technology space
Yahoo bought Tumblr for $1.1 bn in May 2013. This followed previous purchases such as Delicious, an
online-bookmarking service, and GeoCities, which hosts websites. Yahoo owns the photo-sharing site Flickr
Google bought YouTube, a video site, in 2006
Facebook acquired Instagram, a photo-sharing service in 2012
Amazon bought Goodreads, an online book-recommendation service
Twitter acquired UK’s Tweet Deck for $40m in 2011
Apple: In July 2013 Apple acquired Hop Stop, an app for helping people find their way across town using
public transport, and Locationary, which provides information about the locations of local businesses
Apple: in November 2013, Apple announced that it had acquired PrimeSense, Israeli tech business that
developed motion-detection software in gaming sensor Kinect
Google: in February 2014 - Google bought sound authentication firm SlickLogin

Advantages of Vertical Integration
The main advantages of vertical integration are:
1. Control of the supply chain – this helps to
reduce costs and improve the quality of
inputs into the production process
2. Improved access to key raw materials
perhaps at the expense of rival
businesses
3. Better control over retail distribution
channels e.g. pub companies who
ensure that their beers and wines are
sold in tenanted pubs and clubs
4. Removing suppliers, information from
competitors which helps to make a
market less contestable
Lateral / Conglomerate Integration
Lateral integration involves companies joining
together that produce similar but related
products. Examples include:
 Google and You Tube
 Proctor & Gamble acquiring Gillette in
2004
 Whitbread bought Coffee Nation vending
machines (March 2011)
 Microsoft’s takeover of Skype (May
2011)
 SSL International, the manufacturer of
Durex condoms was taken over by
healthcare conglomerate Reckitt
Benckiser (2010)
One of the main advantages of lateral integration
is to exploit economies of scope
Out-sourcing
Over a third of UK companies now do some of
their production work abroad, whilst 10% have
over half of their manufacturing offshore in lower cost locations. Dyson relocated production abroad to
Malaysia, whilst keeping their research and design operations in the UK.
There are several factors promoting outsourcing as a business strategy:
(1) Technological change – Information, communication and telecommunication costs are falling - this
makes it easier to outsource service and manufacturing operations to sub-contractors in other
countries. Technological advances now promote "Just in time delivery" inventory strategies for
the delivery of components and finished products and encourage the development of "virtual
manufacturing"
(2) Increased competition which increases the pressure on businesses to achieve lower costs as a
means of maintaining market share
Business acquisitions – the concept of synergy
Synergy can be defined as when the whole is greater
than the sum of the individual parts
In an acquisition synergy arises in two broad ways:
Many cost saving synergies arise from the greater
scale of the enlarged business. Two firms may be able
to use greater bargaining power to negotiate lower
prices from suppliers, or to demand better profit
margins from their distributors.
Acquisitions nearly always involve the removal or
downsizing of duplicated functions in the two
businesses. For example, if a publicly-quoted
company is taken over by another firm, there is no
need for both businesses to keep their full senior
management structure. There only needs to be one
Chairman, one CEO etc.
Revenue synergies (higher sales) are often harder to
identify and achieve - but they are an important part
of making an acquisition successful. After all, a
successful acquisition should mainly be about helping
a firm to grow more rapidly rather than simply taking
costs out of two businesses put together.

Cineworld and Picturehouse Takeover
In December 2012 a takeover worth £47
million was agreed between Cineworld and
Picturehouse cinema chains. Cineworld
operates 79 cinemas in the UK, the majority
of which are multiplex cinemas. As a result
of this deal Cineworld acquired an
additional 21 cinemas trading under the
Picturehouse brand. These cinemas are
smaller cinemas of between one - three
screens. Picturehouse advertises that the
focus of its film offering is targeted at art-
house and foreign language films.
Cineworld has identified the art-house
cinema sector as a growth opportunity and
has said that it plans to open a further 10
Picturehouse cinemas in locations around
the UK.
The UK’s cinema sector has been
consolidating for years. Three players –
Vue, Odeon & UCI, and Cineworld – now
control 70 per cent of the market between
them.
In April 2013, the Office of Fair Trading
(OFT) referred the completed acquisition by
Cineworld plc of City Screen Limited to the
Competition Commission (CC) after
concerns the merger reduces competition
and could restrict choice and increase
prices for cinema-goers.
The OFT identified that, in five local areas -
Aberdeen, Brighton, Bury St. Edmunds,
Cambridge and Southampton - the deal
raises a realistic prospect of a substantial
lessening of competition.
Source: Adapted from news reports
Joint Ventures between Businesses
 Joint ventures occur when businesses join together to
pursue a common project
 The businesses remain separate in legal terms
 Joint ventures are becoming common as firms want to
benefit from collaborative work in reaching a
mutually-agreed strategic target. An example might be
joint-research projects to share the fixed costs
Examples of joint ventures include:
 Vodafone & Telefónica agreed in 2012 to share more
of their mobile network (which contains more than
18,500 mobile mast sites). This was seen as a
response to Everything Everywhere - JV between T-
Mobile and Orange (current leader in the UK market)
 Vodafone also has a joint venture with Verizon
Wireless in the United States
 BMW and Toyota agreed a partnership in 2011 to co-
operate on hydrogen fuel cells, vehicle electrification,
lightweight materials and a future sports car.
Partnership agreements between competing
automakers are becoming increasingly common in the
industry as manufacturers seek to pool efforts on costly
technologies
 West Coast – a joint venture between Virgin Rail and
Stagecoach
 Google and NASA developing Google Earth
 Hollywood studios combining to fight internet piracy
 Renault-Nissan’s joint venture with Indian firm Bajaj to
produce a £1,276 car
 Intertrust Technologies, a JV between Sony and
Philips
 Alliances in the airline industry e.g. Star Alliance and
One World
 Burger King, the US fast food restaurant chain plans to
open 1,000 stores in China through a new joint venture
with a Turkish private equity business
 Starbucks agreeing a joint venture with Tata Beverages
to break into the Indian retail market
 Nokia Siemens Networks
 Joint Ventures between universities to deliver Massive
Open Online Courses (MOOCs) – a fast-expanding
sector of the higher education industry
 Every one of the world’s 24 biggest carmakers by
sales operates some form of alliance or joint venture
with another large carmaker.

Benefits and Costs of Acquisitions: Evaluation Comments on Mergers and Takeovers
Many takeovers and mergers fail to achieve their aims
1. Debt: Huge financial costs of funding takeovers including the burden of deals that have relied
heavily on loan finance
2. Share price: The need to raise fresh equity through a rights issue to fund a deal which can have a
negative impact on a company's share price. Over the three to five years after the deal on average,
the share price of the acquiring company tends to drop
3. Clash of cultures: Many mergers fail to enhance shareholder value because of clashes of
corporate cultures and a failure to find the all-important "synergy gains“ - Cultural incompatibility is
common in the case of cross-border acquisitions
4. Loss of human capital: The business may suffer a loss of personnel & customers post acquisition
5. Paying too much: With the benefit of hindsight we often see the ‘winners curse’ - i.e. companies
paying over the odds to take control of a business and ending up with little real gain in the medium
term. A good example would be the doomed takeover of ABM-AMRO by Royal Bank of Scotland
6. Job Losses: Integration often leads to sizeable job losses - Google, which acquired Motorola
Mobility (a manufacturer of mobile phones) for $12.5bn recently announced that it will make 20% of
Motorola’s workforce redundant
7. Bad timing – mergers and takeovers that take place towards the end of a sustained boom can often
turn out to be damaging for both businesses. A good example occurred in the UK property market
How takeovers and mergers fit into strategic choice
Innovation
Diversification
International Expansion
Cost leadership
Strategy Method
Organic / interna
Takeovers / m
Joint ventures or stra
Takeovers and mergers are rarely forced on a business - they are optional
If M&A is optional, then there must be some alternatives
E.g. could a joint venture or strategic alliance be as effective as a cross-border ta

with Taylor Woodrow's merger with Wimpey in a £5bn all-shares deal sealed just as property prices
were peaking. Since then house sales have collapsed due to the credit crunch and the merged
business has suffered huge losses

Competing in the Land of the Giants
The UK dairy processing industry is
dominated by a small group of huge milk
processing businesses including Mueller
Wiseman, Arla and Dairy Crest, the UK's
largest supplier.
However a cluster of privately owned
southwest dairy businesses have bucked the
trend of industry consolidation in milk
processing. Rodda’s, maker of the famous
Cornish clotted cream that embellishes the
strawberries at Wimbledon, grew sales by
third in 2012 to £29m. Yeo Valley Food, the
organic yoghurt and ice cream maker in
Blagdon in Somerset, now has sales of about
£200m. Wyke Farms in Bruton is a cheese
maker with sales of £75m.
These small to medium sized businesses
have found profitable segments of the
industry by producing niche and premium
priced products.
How can Smaller Businesses Survive and Thrive?
Over time there is a clear trend towards larger scale
businesses partly because of the pressures of competition; the
need to achieve economies of scale and the effects of
mergers and takeovers. However there are plenty of examples
where businesses are de-merging and divesting themselves
of some of their existing assets. And even in industries where
giant businesses dominate the market place, there is
frequently room for smaller firms to compete and survive
profitably.
1. Many smaller businesses act as a supplier / sub-
contractor to larger enterprises
2. They might take advantage of a low price elasticity
of demand and high income-elasticity of demand
for specialist ‘niche’ goods and services – these
products can be sold at a higher price and with a
bigger profit margin
3. Smaller businesses can avoid diseconomies of
scale associated with larger companies
4. Many smaller businesses are run as lifestyle
enterprises, their owners are looking to achieve a
satisfactory return rather than maximise profits
5. Small-scale businesses are often more innovative,
flexible and nimble in responding to changes in
market demand conditions.
Small Businesses in the British Economy
In the UK small and medium sized enterprises (SMEs) have been the engine of job creation for many years, and, indeed,
since the financial crisis. Employment in SMEs rose by 2.0% between 2008 and 2012 while large firms reduced their
headcount by 1.8%. Cost cutting and redundancies in large companies and the public sector have acted as a spur to
self-employment and business start-ups.
But surviving and expanding are tough for SMEs. The great majority of small businesses are sole traders or employ a
handful of people. Small firms tend to stay small and have a high mortality rate. In 2011, 261,000 firms employing fewer
than 100 people were formed in the UK - and 229,000 died. Most new jobs in SMEs come with the initial creation of the
business, not from subsequent growth. Despite a high mortality rate, the number of UK small firms has increased to
reach 4.8 million by 2012, a rise of 39% over 12 years. Over the same period the number of large businesses employing
more than 250 people fell by 19%. What is driving the growth in small businesses?
The expansion of services – the dominant sector in Western economies – has been a boon for entrepreneurs. In many
service industries capital costs are low, making it easier for small players to enter. Changing consumer tastes and rising
incomes have led to growing demand for customisation which favours nimble, niche players. Among those of working
age a desire for greater independence has helped boost the ranks of the self-employed. Advances in the internet,
computing and telecommunications have eroded some of the advantages of scale previously enjoyed by big business.
In reality, large and small companies are mutually dependent. The auto industry relies on networks of small companies
providing them with components. Small companies are a source of new ideas which, in sectors such as technology and
pharmaceuticals, are often exploited by large businesses. Small firms in turn benefit from knowledge ‘spill-overs’
generated by larger firms and rely upon larger suppliers for business and, at times, credit. Meanwhile, the high failure
rate of small businesses can be seen as a dynamic process, a necessary form of creative destruction which, in time,
allows a few winners – the Apples, Googles and Facebooks – to become behemoths.
Source: Ian Stewart, Deloitte Business Briefing, July 2013

Demergers and Divestment
 This is when a firm decides to split into separate firms
 A partial demerger means that the parent company retains a stake in the demerged business
 Demergers can also result from government intervention - for example BAA has been compelled by
the UK Competition Commission to sell off some airports in Britain including Gatwick & Stansted
 Some of the key motivations for de-merger include:
o Focusing on core businesses to streamline costs and improve profit margins
o Reduce the risk of diseconomies of scale and diseconomies of scope by reducing the
range of functions in a business, lower management costs
o Raise money from asset sales and return to shareholders
o A defensive tactic to avoid the attention of the competition authorities who might be
investigating possible monopoly power in an industry / market
Examples of recent demergers
Demergers are becoming increasingly common in many industries – here are ten examples:
1. The US pharmaceutical company Pfizer sold their infant nutrition business to Nestle and announced
a demerger of the animal health business (creating a new company called Zoetis)
2. Demerger of Cadbury's US drinks business creating a business called Dr Pepper Snapple Group
3. Severn Trent Water demerged its waste management business Biffa
4. Demerger of British Gas into a gas pipeline business Transco + an oil and gas exploration company
5. Talk Talk demerged from Carphone Warehouse in 2010
6. Fosters Group de-merging its two main operating divisions – one focusing on beer, the other on wine
7. Punch and Spirit pub groups created out of demerger of Punch Taverns in 2011. Punch Taverns had
seen a 95% fall in the share price of the business in the years leading up to the demerger. The
business had huge debts and selling off parts of the business was a way of cutting that debt.
8. US food giant Sara Lee sold off their coffee business Douwe Egberts
9. Quantas demerged their airline business and run stand-alone domestic and international airline
businesses with each having their own profit and loss account
10. News International announced plans in 2012 to demerge their Film and TV and Publishing
businesses. News International as a whole earned $25.3bn in revenue in 2012 with an operating
profit of $4.2bn. The business will be split into two.
FilmandTV
•Fox News
•20th Century Fox
•Sky
•Fox Television
Publishing
•Dow Jones
•Wall Street Journal
•New York Post
•The Times
•The Sun
•Harper Collins

3. Calculating the Revenue of a Firm
Revenue is the income generated from the sale of goods and services in a market
 Average Revenue (AR) = Price per unit = total revenue / output (the AR curve is the same as the
demand curve)
 Marginal Revenue (MR) = the change in revenue from selling one extra unit of output
 Total Revenue (TR) = Price per unit x quantity
The table below shows the demand for a product where there is a downward sloping demand curve.
Price per unit
(average revenue)
Quantity Demanded
(Qd)
Total Revenue
(TR) (PxQ)
Marginal Revenue
(MR)
£s units £s £s
340 460 156400
310 580 179800 195
280 700 196000 135
250 820 205000 75
220 940 206800 15
190 1060 201400 -45
Average and Marginal Revenue
 In the table above, as price per unit falls, demand expands and total revenue rises although because
average revenue falls as more units are sold, this causes marginal revenue to decline
 Eventually marginal revenue becomes negative, a further fall in price (e.g. from £220 to £190)
causes total revenue to fall.
The Relationship between Elasticity of Demand and Total Revenue
 When a firm faces a perfectly elastic demand curve, then average revenue = marginal revenue –
each unit sold add the same amount to total revenue
 However, most businesses face a downward sloping demand curve! And because the price per unit
must be cut to sell extra units, therefore MR lies below AR.
 MR curve will fall at twice the rate of the AR curve.
You don’t have to prove this for exams – the marginal revenue curve has twice the slope of the AR curve!
Maximum Revenue
 Maximum total revenue occurs where marginal revenue is zero: no more revenue can be achieved
from producing an extra unit of output
 This point is directly underneath the mid-point of a linear demand curve
 When marginal revenue is zero, the price elasticity of demand = 1
 When marginal revenue is zero, if prices were cut total revenue would fall, and if prices were raised
total revenue would fall
Total revenue when demand has low price elasticity
If price elasticity of demand < 1 (i.e. demand is inelastic), if prices are cut then demand rises by a smaller
proportion. Cutting price when demand is relatively inelastic means total revenue falls, or MR<0

Total revenue is shown by the area underneath the firm’s demand curve (average revenue curve).
A shift in the average revenue curve (AR) will also bring about a shift in the marginal revenue curve (MR)
Seasonal revenues: Many businesses experience seasonal fluctuations in revenues because the strength
of demand ebbs and flow at different times of the year. Good examples of seasonal shifts in demand and
revenues include beer producers, chocolate and card retailers, tourist attractions, online dating sites,
jewellers and perfumery businesses.
Output (Q)
Revenue
Total Revenue
(TR)
Marginal Revenue
(MR)
Average Revenue
(Demand) AR
Total revenue is
maximized when
MR = 0
Price elasticity of
demand = 1 at this
output
Ped >1 for a price
fall along this
length of AR
Costs
Output (Q)
Average revenue AR
Marginal revenue MRQ1
P1
Total revenue at price P1 where marginal
revenue is zero
A rise in price to P2 causes a reduction in total
revenue
P2
Q2
Total revenue at price P2

4. Calculating a Firm’s Costs
 In the short run, at least one factor of
production is fixed; this means that output can
be increased by adding more variable factors
such as employing more workers and buying in
more raw materials
Fixed costs
 Fixed costs do not change with output, firms
must pay these even if they shut down
 Examples include the rental costs of buildings;
the costs of leasing or purchasing capital
equipment; the annual business rate charged by
local authorities; the costs of employing full-time
contracted salaried staff; the costs of meeting
interest payments on loans; the depreciation of
fixed capital (due solely to age) and also the
costs of business insurance.
 Any business with significant capacity will
have high fixed costs, for example a vehicle
manufacturer that spends millions of pounds
building a new factory and installing expensive
and bulky capital equipment.
Fixed costs are the overhead costs of a business.
 Total fixed costs (TFC)
 Average fixed cost (AFC) = TFC / output
 Average fixed costs must fall continuously as
output increases because total fixed costs are
being spread over a higher level of production.
A change in fixed costs has no effect on marginal costs.
Marginal costs relate only to variable costs!
Variable Costs
 Variable costs vary directly with output –
when output is zero, variable costs will be zero
but as production increases, total variable costs
will rise
 Examples of variable costs include the costs of
raw materials and components, packaging and distribution costs, the wages of part-time staff or
employees paid by the hour, the costs of electricity and gas and the depreciation of capital inputs
due to wear and tear
Average variable cost (AVC) = total variable costs (TVC) /output (Q)
Total Cost (TC) = fixed costs + variable costs
Average Total Cost (ATC or AC)
 Average total cost is the cost per unit produced
 Average total cost (ATC) = total cost (TC) / output (Q)
Airline Costs – The Last Passenger is Key!
In 2012 the Wall Street Journal published an
investigation into the operating costs of
airlines in the United States. They started their
research with a simple question. On an
airplane carrying 100 passengers, how many
customers does it take, on average, to cover
the cost of the flight? The answer reveals
much about the low profit margins for many
airlines and emphasizes the need for airlines
to use pricing tactics to fill their planes and
generate as much extra revenue as possible.
On average it takes 99 paying passengers to
cover all costs and that only the 100th
passenger takes them into profit!
Some of the key costs for an airline are:
 Aviation fuel
 Salaries for airline staff
 Costs of buying and leasing planes
 Maintenance of assets including
planes
 Federal taxes
 Crash insurance
 Compensation paid for bumped
passengers or lost luggage
 In-flight catering costs
 Rental fees for gates & ticket
counters
 Landing fees
 Advertising and legal fees
Source: Wall Street Journal, June 2012

Marginal Cost
 Marginal cost is the change in total costs from
increasing output by one extra unit
 The marginal cost of supplying extra units of output is
linked with the marginal productivity of labour
 The law of diminishing returns implies that marginal
cost will eventually rise as output increases
 At some point, rising marginal cost will lead to a rise in
average total cost. This happens when the rise in AVC is
greater than the fall in AFC as output (Q) increases
Calculating Costs – A Numerical Example
A numerical example of short run costs is shown in the table
below. Fixed costs are assumed to be constant at £200. Variable costs increase as more output is produced.
Output (Q) Total Fixed Costs
(TFC)
Total Variable
Costs (TVC)
Total Cost Average Cost Per
Unit
Marginal Cost
(the change in
total cost from a
one unit change
in output)
(TC= TFC +
TVC)
(AC = TC/Q)
0 200 0 200
50 200 100 300 6 2
100 200 180 400 4 2
150 200 230 450 3 1
200 200 260 460 2.3 0.2
250 200 280 465 1.86 0.1
300 200 290 480 1.6 0.3
350 200 325 525 1.5 0.9
400 200 400 600 1.5 1.5
450 200 610 810 1.8 4.2
500 200 750 1050 2.1 4.8
 In our example, average cost per unit is minimised at a range of output - 350 and 400 units.
 Thereafter, because the marginal cost of production exceeds the previous average, so average cost
rises (for example the marginal cost of each extra unit between 450 and 500 is 4.8 and this increase
in output has the effect of raising the cost per unit from 1.8 to 2.1).
An example of fixed and variable costs in equation format
If for example, the short-run total costs of a firm are given by the formula
SRTC = $(10 000 + 5X2
) where X is the level of output.
 The firm’s total fixed costs are $10,000
 The firm’s average fixed costs are $10,000 / X
 If the level of output produced is 50 units, total costs will be $10,000 + $2,500 = $12,500
Marginal costs of farming
Farmers in the United States are
facing higher marginal costs for
each area of their land cultivated.
According to North Dakota State
University, the cost per acre in the
state for wheat has surged from
$2.89 in 2004 to $5.03 in 2011 due
to more expensive seeds,
fertilizers, fuel and labour.

Short Run Cost Curves
 In the diagram below, when diminishing returns set in (beyond output Q1) marginal cost rises
 Average cost per unit falls until output Q2 where the rise in average variable cost (AVC) equates
with the fall in average fixed cost (AFC)
 Output Q2 is the lowest point of the ATC curve. This is the output of productive efficiency
 The marginal cost curve (MC) will cut both the average variable cost curve (AVC) and average total
cost curve (ATC) at their minimum point
Costs
Output (Q)
Average Fixed
Cost (AFC)
Average
Variable Cost
(AVC)
Average Total
Cost (ATC)
Marginal Cost
(MC)
Q1 Q2

The Effects of an Increase in Variable Costs
 A rise in variable costs of production – perhaps due to a rise in oil and gas prices or a rise in the
national minimum wage - leads to an upward shift both in marginal and average total cost
 The firm is not able to supply as much output at the same price
 The effect is that of an inward shift in the supply curve of a business in a competitive market
Showing Changes in Fixed Costs
 An increase in fixed costs has no effect on the variable costs of production
 This means that only the average total cost curve shifts
 There is no change on the marginal cost + no change in the profit maximising price and output
 The effects of an increase in the fixed costs of a business are shown in the next diagram
Costs
Output (Q)
Average
Variable Cost
(AVC1)
Average Total
Cost (ATC1)
Marginal Cost
(MC1)
MC2 AC2
AVC2
Costs
Output (Q)
AC1
MC
AC2 (after rise
in fixed costs)

Rising costs for household goods giant Unilever
Unilever - the world’s second-biggest consumer-goods company – has announced that profitability might fall even after it
increased prices to offset soaring costs for the commodities used to make its products. Unilever, the manufacturer of
numerous household-name brands including Dove soap, Bertolli sauces, Coleman’s mustard, Vaseline, Lynx deodorant,
Knorr soup, Lipton tea, Magnum ice cream and Domestos bleach has been affected by a sharp rise in the prices of
ingredients, oil and packaging. It has chosen to pass on some of the rise in costs to its main customers - supermarkets
and grocery stores around the world.
In response the CEO of Unilever has attempt to streamlining packaging, paring logistics, sourcing and purchasing costs.
A cut in overheads will also help to maintain profitability. All food companies are grappling with higher costs, Unilever is
in direct competition with Proctor and Gamble, Danone and Nestle. They all have significant buying power - for example,
Unilever each year buys up to 12% of the world’s black tea crop and 6% of its tomatoes. It is one of the world’s largest
buyers of palm oil, which it uses in margarine and skincare products. The world price of palm oil has risen as much as 40
percent in the last year.
Cost curves for businesses with fixed costs only
The diagram below shows the cost and revenue curves of a monopoly producer who’s only cost of
production is a fixed cost.
If the marginal cost of production is zero, then total cost will stay the same as output increases. The result is
that the average fixed cost curve is the same as the average total cost curve and will fall continuously as
production expands.
Costs
Output (Q)
Average
Fixed Cost
= Average
Total Cost

Case Study: The Cost and Market Price of Gas
High gas prices impact on millions of households whose energy bills have soared in recent years and have
led to a steep increase in fuel poverty among lower-income families. A standard gas bill for UK consumers
getting their suppliers from Centrica – owned by British Gas - breaks down as follows:
 56% - cost of gas bought from the wholesale market
 21% - cost of delivering gas to the home – including the cost of building, maintaining and operating
the local gas pipes
 10% - cost of obligations imposed by government such as environmental taxes plus VAT at 5%
 8% - other operating costs of British Gas – including the costs of building, maintaining and operating
the high pressure gas transmission networks
 5% - profit for gas suppliers
The average credit gas bill for a typical consumer was £836 in 2012. This was more than double the 2001
low in real terms. In 2012, Centrica earned a profit of £48 on the average UK residential dual-fuel bill of
£1,188
The UK gas supply industry is an oligopoly dominated by British Gas, EDF, E.ON, Npower, Scottish Power,
and Scottish & Southern.
The industry watchdog Consumer Focus estimates that 6.5m UK households spend more than ten per cent
of their household income on energy bills, which is defined as being in fuel poverty. Gas companies have
been heavily criticised for being quick to raise their prices when gas prices on the wholesale market head
higher, but delay price reductions when world prices dip.

5. Production in the
Short and the Long
Run
Production Functions
The production function relates the quantity of
factor inputs used by a business to the amount
of output that result. We use three measures of
production and productivity:
o Total product (or total output). In
manufacturing industries such as motor
vehicles and DVD players, it is
straightforward to measure how much
output is being produced. In service or
knowledge industries, where output is less “tangible” it is harder to measure productivity.
o Average product measures output per-worker-employed or output-per-unit of capital.
o Marginal product is the change in output from increasing the number of workers used by one
person, or by adding one more machine to the production process in the short run.
The length of time required for the long run varies from sector to sector. In the nuclear power industry for example, it can
take many years to commission new nuclear power plant and capacity. This is something the UK government has to
consider as it reviews our future sources of energy.
Short Run Production Function
 The short run is a time period where at least one factor of production is in fixed supply
 A business has chosen it’s scale of production and must stick with this in the short run
 We assume that the quantity of plant and machinery is fixed and that production can be altered by
changing variable inputs such as labour, raw materials and energy
Diminishing Returns
 In the short run, the law of diminishing returns states that as more units of a variable input are
added to fixed amounts of land and capital, the change in total output will first rise and then fall
 Diminishing returns to labour occurs when marginal product of labour starts to fall. This means
that total output will be increasing at a decreasing rate
What might cause marginal product to fall? One explanation is that, beyond a certain point, new workers will
not have as much capital equipment to work with so it becomes diluted among a larger workforce.
In the following numerical example, we assume that there is a fixed supply of capital (20 units) to which
extra units of labour are added.
 Initially, marginal product is rising – e.g. the 4th
worker adds 26 to output and the 5th
worker adds 28
and the 6th
worker increases output by 29.
 Marginal product then starts to fall. The 7th
worker supplies 26 units and the 8th
worker just 20 added
units. At this point production demonstrates diminishing returns.
 Total output will continue to rise as long as marginal product is positive
 Average product will rise if marginal product > average product

The Law of Diminishing Returns
Capital Input Labour Input Total Output Marginal Product Average Product of Labour
20 1 5 5
20 2 16 11 8
20 3 30 14 10
20 4 56 26 14
20 5 85 28 17
20 6 114 29 19
20 7 140 26 20
20 8 160 20 20
20 9 171 11 19
20 10 180 9 18
Diagram to show diminishing returns as extra labour is employed
Average product rises as long as marginal product is greater than the average – e.g. when the seventh
worker is added the marginal gain in output is 26 and this drags the average up from 19 to 20 units. Once
marginal product is below the average as it is with the ninth worker employed then the average must decline.
Criticisms of the Law of Diminishing Returns
 How realistic is this assumption of diminishing returns? Surely ambitious and successful businesses
will do their level best to avoid such a problem emerging?
 It is now widely recognised that the effects of globalisation and the ability of trans-national
businesses to source their inputs from more than one country and engage in transfers of business
technology, makes diminishing returns less relevant as a concept.
 Many businesses are multi-plant meaning that they operate factories in different locations – they
can switch output to meet changing demand.
Total
Output
(Q)
Units of Labour Employed (L)
(Q)Slope of the curve gives the
marginal product of labour
Diminishing returns are apparent
here – total output is rising but at a
decreasing rate

Long Run Production - Returns to Scale
In the long run, all factors of production are variable. How the output of a business responds to a change
in factor inputs is called returns to scale.
Numerical example of long run returns to scale
Units of
Capital
Units of
Labour
Total
Output
% Change in
Inputs
% Change in
Output
Returns to Scale
20 150 3000
40 300 7500 100 150 Increasing
60 450 12000 50 60 Increasing
80 600 16000 33 33 Constant
100 750 18000 25 13 Decreasing
 When we double the factor inputs from (150L + 20K) to (300L +
40K) the % change in output is 150% - increasing returns
 When the scale of production is changed from (600L + 80K0 to
(750L + 100K) then the percentage change in output (13%) is
less than the change in inputs (25%) i.e. decreasing returns
 Increasing returns to scale occur when the % change in output
> % change in inputs
 Decreasing returns to scale occur when the % change in
output < % change in inputs
 Constant returns to scale occur when the % change in output
= % change in inputs
The nature of the returns to scale affects the shape of a business’s long run average cost curve
Finding an optimal mix between labour and capital
In the long run businesses will be looking to find an
output that combines labour and capital in a way that
maximises productivity and reduces unit costs
towards their lowest level.
This may involve a process of capital-labour
substitution where capital machinery and new
technology replaces some of the labour input.
In many industries over the years we have seen a
rise in the capital intensity of production - good
examples include farming, banking and retailing.
Robotic technology is extensively used in many
manufacturing / assembly industries such as cars
and semi-conductors. The image on the left is of a
Ford car assembly factory in India.

6. Long Run Costs: Economies of Scale
A huge distribution centre operated by Sainsburys – with lots of different economies of scale in action!
Economies of Scale
 In the long run all costs are variable and the scale of production can change (no fixed inputs)
 Economies of scale are the cost advantages from expanding the scale of production in the long
run. The effect is to reduce average costs over a range of output.
 These lower costs represent an improvement in productive efficiency and can give a business a
competitive advantage in a market. They lead to lower prices and higher profits – this is called a
positive sum game for producers and consumers (i.e. the welfare of both will improve)
 We make no distinction between fixed and variable costs in the long run because all factors of
production can be varied.
 As long as the long run average total cost curve (LRAC) is declining, then internal economies of
scale are being exploited. The table below shows a numerical example of falling LRAC
Long Run Output (Units) Total Costs (£s) Long Run Average Cost (£ per unit)
1000 12000 12
2000 20000 10
5000 45000 9
10000 80000 8
20000 144000 7.2
50000 330000 6.6
100000 640000 6.4
500000 3000000 6

Returns to Scale and Costs in the Long Run
The table below shows how changes in the scale of production can, if increasing returns to scale are
exploited, lead to lower average costs.
Factor Inputs Production Costs
(K) (La) (L) (Q) (TC) (TC/Q)
Capital Land Labour Output Total Cost Average
Cost
Scale A 5 3 4 100 3256 32.6
Scale B 10 6 8 300 6512 21.7
Scale C 15 9 12 500 9768 19.5
Costs: Assume the cost of each unit of capital = £600, Land = £80 and Labour = £200
Because the % change in output exceeds the % change in factor inputs used, then, although total costs rise,
the average cost per unit falls as the business expands from scale A to B to C
Examples of Increasing Returns to Scale
Much of the new thinking in economics focuses on the increasing returns available to growing businesses:
An example of this is the software business.
1. The overhead costs of developing new software programs or computer games are huge - often
running into hundreds of millions of dollars
2. The marginal cost of one extra copy for sale is close to zero, perhaps just a few cents or pennies.
3. If a company can establish itself in the market, positive feedback from consumers will expand the
installed customer base, raise demand and encourage the firm to increase production.
4. Because marginal cost is low, the extra output reduces average costs creating economies of size.
Capacity Utilisation, Fixed Costs and Profits
 Lower costs normally mean higher profits and increasing financial returns for the shareholders.
What is true for software developers is also important for telecoms companies, transport operators
and music distributors.
 We find across many different markets that, when a high percentage of costs are fixed the higher the
level of production the lower will be the average cost of production. Strong demand means that
capacity utilization rates are high and this lowers the unit cost of supply.
Long Run Average Cost Curve
 The long run average cost curve (LRAC) is known as the ‘envelope curve’ and is usually drawn on
the assumption of their being an infinite number of plant sizes – hence its smooth appearance in the
next diagram below.
 The points of tangency between LRAC and SRAC curves do not occur at the minimum points of
the SRAC curves except at the point where the minimum efficient scale (MES) is achieved.
 If LRAC is falling when output is increasing then the firm is experiencing economies of scale. For
example a doubling of factor inputs might lead to a more than doubling of output.
 Conversely, When LRAC eventually starts to rise then the firm experiences diseconomies of scale,
and, If LRAC is constant, then the firm is experiencing constant returns to scale
 The working assumption is that a business will choose the least-cost method of production in the
long run. Moving down the LRAC means there are cost advantages from a bigger scale of
operations.

What are the main Examples of Internal Economies of Scale? (IEoS)
Internal economies of scale come from the long-term growth of the firm. Examples include:
1. Technical economies of scale:
These refer to gains in productivity from scaling up production.
a. Expensive (indivisible) capital inputs: Large-scale businesses can afford to invest in
specialist capital machinery. For example, a supermarket might invest in database
technology that improves stock control and reduces transportation and distribution costs.
b. Specialization of the workforce: Larger firms can split the production processes into
separate tasks to boost productivity. Examples include the use of division of labour in the
mass production of motor vehicles and in manufacturing electronic products.
c. The law of increased dimensions (also known as the “container principle”) This is linked
to the cubic law where doubling the height and width of a tanker or building leads to a more
than proportionate increase in the cubic capacity
i. The application of this law opens up the possibility of scale economies in distribution
and freight industries and also in travel and leisure sectors with the emergence of
super-cruisers such as P&O’s Ventura. Consider the new generation of super-
tankers and the development of enormous passenger aircraft such as the Airbus
280 which is capable of carrying over 500 passengers on long haul flights.
ii. The law of increased dimensions is also important in the energy sectors and in
industries such as office rental and warehousing. Amazon for example has invested
in several huge warehouses at its central distribution points – capable of storing
hundreds of thousands of items.
d. Learning by doing: The average costs of production decline in real terms as a result of
production experience as businesses cut waste and find the most productive means of
producing output on a bigger scale. Evidence across a wide range of industries into so-
called “progress ratios”, or “experience curves”, indicate that unit manufacturing costs
typically fall by between 70% and 90% with each doubling of cumulative output.
LRAC
SRAC1
SRAC2 SRAC3
Costs
AC3
The Long Run Average Cost Curve (LRAC)
AC1
AC2
Q2 Q3 Output (Q)Q1

2. Marketing Economies - Monopsony Power:
a. A large firm can purchase its factor inputs in bulk at discounted prices if it has
monopsony (buying) power. A good example would be the ability of the electricity
generators to negotiate lower prices when finalizing coal and gas supply contracts
b. Large food retailers have monopsony power when purchasing their supplies from farmers
and wine growers and in completing supply contracts from food processing businesses.
Other controversial examples of the use of monopsony power include the prices paid by
coffee roasters and other middlemen to coffee producers in some of the poorest countries
3. Managerial economies of scale: This is a form of division of labour where firms can employ
specialists to supervise production systems. Better management; increased investment in human
resources and the use of specialist equipment, such as networked computers can improve
communication, raise productivity and thereby reduce unit costs.
4. Financial economies of scale: Larger firms are usually rated by the financial markets to be more
‘credit worthy’ and have access to credit with favourable rates of borrowing. In contrast, smaller
firms often pay higher rates of interest on overdrafts and loans. Businesses quoted on the stock
market can normally raise new financial capital more cheaply through the sale of equities to the
capital market. The credit crunch and fragility of the banking system has made raising finance harder
for businesses of all sizes – bank overdraft and loan interest rates have increased across the board,
but it remains true that larger corporations can still access credit at a cheaper cost.
5. Network economies of scale: There is growing interest in the concept of a network economy.
Some networks and services have huge potential for economies of scale. That is, as they are more
widely used (or adopted), they become more valuable to the business that provides them.
Case Study: Small businesses and financial economies of scale
A Bank of England survey on financial and credit conditions finds that smaller businesses are finding it tough to get the
credit they need to finance an upturn in sales and production.
Interest rate spreads on new loans are rising and it is larger firms that seem to be benefitting from lower borrowing costs.
According to the report “larger businesses are enjoying a reduction in the cost of borrowing and improved access to
credit as banks favour lower-risk custom.”
The main commercial banks continue to adopt a risk-averse approach to new lending and this may hamper prospects of
recovery. Unsecured loans for consumers have also become harder to get and more expensive despite the ultra-low
interest rate policy of the Bank of England. In 2006, the top 10 average rate for a £3,000 personal loan was 6.49%, but
today it is 14.92%, analysis by price comparison website moneysupermarket.com has shown.
Source: Tutor2u economics blog, April 2010

What are Network Economies of Scale?
The power of networks is becoming increasingly recognized in the
economics of long run costs, revenues and profits.
Many networks have huge potential for economies of scale. That is, as
they are more widely used (or adopted), they become more valuable to
the business that provides them.
Good examples to use include online auction sites such as eBay, social
networking sites, wireless service providers, air and rail transport
networks and businesses such as Amazon.
In most cases, the marginal cost of adding one more user or customer to a network is close to zero, but the resulting
financial benefits may be huge because each new user to the network can then interact, trade with all of the existing
members or parts of the network.
Given the high fixed costs of establishing a network, the more users there are the lower are the fixed costs per unit.
Thus as the network expands, not only are there potential gains from extra revenues, but the long run cost per user
diminishes - an internal economy of scale.
In some cases an industry that requires a network to fulfill customer needs and wants across a country or region might
be classified as a natural monopoly - an industry where long run average cost falls over a huge range of output and
where the minimum efficient scale is a large percentage of market demand.
Consider as examples the networks required by the major utilities such as water, gas, electricity and (fixed line)
broadband suppliers. And perhaps businesses such as Network Rail and the Royal Mail might also claim to have aspects
of a natural monopoly given the requirement for the former to maintain and improve a national rail infrastructure and, for
the latter, to keep a universal postal service running to add postal addresses in the country - this is of course a loss-
making aspect of their business model.
Where there are strong grounds for believing an industry is a natural monopoly, there might be a case for nationalizing
and/or regulating the network element of the business but introducing competition into the actual service provision - e.g.
franchise bids for train operating companies, and partial or complete deregulation of parcel and letter collection, sorting
and delivery.
Source: Tutor2u Economics Blog

Analysis: Economies of Scale – The Effects on Price, Output and Profits
 Consider the diagram below - scale economies allow a supplier to move from SRAC1 to SRAC2
 A profit maximizing producer will produce at a higher output (Q2) and charge a lower price (P2) as a
result – but the total profit is also much higher (compare the two shaded regions)
 Both consumer and producer surplus has increased – there has been an improvement in economic
welfare and efficiency – the key is whether these cost savings are passed onto consumers!
Analysis Diagram for External Economies of Scale (EEoS)
The diagram below shows the effects of external economies of scale that benefit the majority of businesses
that operate in a given industry.
Costs
Output (Q)
SRAC1
SRAC2
AR
(Demand)
MR
MC1
MC2
P1
P2
Q1 Q2
Profit at Price P1
Profit at Price P2
Cost
(Per unit of output)
LRAC1
B
Economies of Scale
LRAC2
External
Economies of
Scale
C
A
Output

 External economies of scale occur outside of a firm but within an industry.
 For example investment in a better transport network servicing an industry will resulting in a
decrease in costs for a company working within that industry
 Investment in industry-related infrastructure including telecommunications can cut costs for all
 Another example is the development of research and development facilities in local universities
that several businesses in an area can benefit from
 Likewise, the relocation of component suppliers and other support businesses close to the centre
of manufacturing are also an external cost saving
 Agglomeration economies may also result from the clustering of businesses in a distinct
geographical location e.g. software in Silicon Valley or investment banks in the City of London
Case Studies in External Economies of Scale
Formula One
Britain has a history of providing a base for some of the most
successful teams in Formula One. McLaren are based in Woking
but Renault, Honda, Williams and Red Bull are all clustered in the
east Midlands. Partly this is an accident of history - namely the
availability of disused airfields after the war.
But the cluster of F1 teams is also a good example of the external
economies of scale that can be generated when a group of
producers develop and expand in a relatively small geographical
area.
Most of the teams currently racing are based in the UK, along with
their R&D operations. A whole network of industries, such as
component suppliers, engineering and design firms, have sprung
up in Britain, mostly in central England, to serve the sport both here and abroad. F1 also helps to support a
far larger motorsport industry in the UK, for example rally car racing and all its associated industries.
Estimates of the total number of jobs dependent on motorsport in the UK vary between 45,000 and 110,000.
Geoff Goddard, professor in Motorsport Engineering Design at Oxford Brookes University, estimates that it
accounts for 1 per cent of GDP, not insignificant when compared to car manufacturers, which represent
about 5 per cent.
Science Cities
Science cities are knowledge clusters that bring together higher education expertise and entrepreneurial
zeal. Their number continues to grow
from California and Boston in the
USA, Cambridge in the UK,
Education City in Qatar, Science City
in Zurich and Digital Media City in
Seoul.
In London there is much excitement
about Tech City, an area around
Shoreditch and Old Street in east
London which is home to a growing
number of technology digital and
creative companies. It is also known
as Silicon Roundabout and recent
estimates suggest there are 3,200
firms in the area employing some 48,000 people
Source: Tutor2u Economics Blog

Economies of Scale – The Importance of Market Demand
 The market structure of an industry is affected by the
extent of economies of scale available to individual
suppliers and by the total size of market demand.
 In many industries, it is possible for smaller firms to make
a profit because the cost disadvantages they face are
relatively small. Or because product differentiation
allows a business to charge a price premium to
consumers which more than covers their higher costs.
 A good example is the retail market for furniture. The
industry has major players in different segments (e.g. flat-
pack and designer furniture) including the Swedish giant
IKEA. However, much of the market is taken by smaller-
scale suppliers with consumers willing to pay higher prices
for bespoke furniture owing to the low price elasticity of
demand for high-quality, hand crafted furniture products.
 Small-scale manufacturers can extract the consumer
surplus that is present when demand is estimated to have
a low elasticity of demand.
Economies of Scope
 Economies of scope occur where it is cheaper to
produce a range of products rather than specialize in just
a handful of products.
For example, in the competitive world of postal services and
business logistics, service providers such as Royal Mail, UK Mail,
Deutsche Post and parcel carriers including TNT, UPS, and FedEx
are broadening the range of their services and making better use
of their collection, sorting and distribution networks to reduce costs
and earn higher profits from higher-profit-margin and fast growing
markets.
 A company’s management structure, administration
systems and marketing departments are capable of
carrying out these functions for more than one product.
 Expanding the product range to exploit the value of
existing brands is a way of exploiting economies of scope.
 A good example of “brand extension” is the Easy Group
under the control of Stelios where the distinctive Easy
Group business model has been applied (with varying
degrees of success) to a wide range of markets – easy
Pizza, easy Cinema, easy Car rental, easy Bus and easy
Hotel to name just a handful!
 Procter and Gamble is the largest consumer household
products maker in the world. Its brands include Crest,
Duracell, Gillette, Pantene, and Tide, to name just a few.
Twenty four of its brands make over $1 billion in sales
annually.
Another example of an economy of scope might be a restaurant
that has catering facilities and uses it for multiple occasions – as a
coffee shop during the day and as a supper-bar and jazz room in
the evenings. A computing business can use its network and
databases for many different uses.
Has global outsourcing peaked?
Outsourcing involves passing work to
a subcontractor who takes on that
role. Over the past few decades
companies have contracted out
everything from mopping the floors to
spotting the flaws in their internet
security. One estimate is that $100
billion-worth of new contracts are
signed every year. In Britain, 10% of
workers toil away in “outsourced” jobs
and companies spend $200 billion a
year on outsourcing.
But is it as useful as its fans claim?
There are signs that outsourcing often
goes wrong, and that companies are
rethinking their approach to it. Recent
figures suggest that the value of
outsourcing contracts is falling
steeply.
Some of the worst business disasters of
recent years have been caused or
aggravated by outsourcing. Eight
years ago Boeing, America’s biggest
aero plane-maker, decided to hire
contractors to do most of the grunt
work on its new 787 Dreamliner. The
result was a nightmare. Some of the
parts did not fit together. Some of the
dozens of sub-contractors failed to
deliver their components on time,
despite having sub-contracted their
work to sub-sub-contractors.
Sometimes companies squeeze their
contractors so hard that they are
forced to cut corners. Vendors may
overpromise in order to win a contract
and then fail to deliver. And service
companies, contract out customer
complaints to foreign call centres and
then wonder why their customers hate
them.
When outsourcing goes wrong, it is
hard to put right.

Key global trends affecting business
strategies
A new report by consultants Ernst & Young
examines six broad, long-term developments
which shape business around the globe. In
summary, the six trends are:
(1) Emerging markets increase their global
power
(2) Cleantech becomes a competitive
advantage
(3) Global banking seeks recovery through
transformation
(4) Governments enhance ties with the private
sector
(5) Rapid technology innovation creates a
smart, mobile world
(6) Demographic shifts transform the global
workforce
The Importance of Minimum Efficient Scale (MES)
 The minimum efficient scale (MES) is the scale of output where the internal economies of scale
have been fully exploited.
 MES corresponds to the lowest point on the long run average cost curve and is also known as
an output range over which a business achieves productive efficiency.
 MES is not a single output level – more likely, the MES is a range of outputs where the firm
achieves constant returns to scale and has reached the lowest feasible cost per unit.
The minimum efficient scale depends on the nature of costs of production in a specific industry.
1. How many firms can "fit" in a market? It depends on the size of the market compared to the size of
the minimum efficient scale
2. In industries where the ratio of fixed to variable costs is high, there is scope for reducing unit cost
by increasing the scale of output. This is likely to result in a concentrated market structure (e.g. an
oligopoly, a duopoly or a monopoly) – indeed
economies of scale may act as a barrier to
entry because existing firms have achieved
cost advantages and they then can force
prices down in the event of new businesses
coming in
3. There might be only limited opportunities for
scale economies such that the MES turns out
to be a small % of market demand. It is likely
that the market will be competitive with
many suppliers able to achieve the MES. An
example might be a large number of hotels in
a city centre or a cluster of restaurants in a
town. Much depends on how we define the
market!
4. With a natural monopoly, the long run
average cost curve continues to fall over a
huge range of output, suggesting that there
may be room for perhaps one or two
suppliers to fully exploit all of the available
economies of scale when meeting market
demand.
Costs
Revenues
Output (Q)MES
LRAC
Increasing return to scale –
economies of scale - falling LRAC
Decreasing returns –
diseconomies of scale

7. Diseconomies of Scale
Diseconomies are the result of decreasing returns to scale and
lead to a rise in average cost
Diseconomies of scale in a large business may be due to:
1. Control – monitoring the productivity and the quality of
output from thousands of employees in big, complex
corporations is imperfect and expensive – this links to
the concept of the principal-agent problem i.e. the
difficulties of shareholders monitoring the performance of
managers.
2. Co-ordination - it can be difficult to co-ordinate
complicated production processes across several plants
in different locations and countries. Achieving efficient
flows of information in large businesses is expensive
as is the cost of managing supply contracts with
hundreds of suppliers at different points of an industry’s
supply chain.
3. Co-operation - workers in large firms may develop a
sense of alienation and loss of morale. If they do not
consider themselves to be an integral part of the
business, their productivity may fall leading to wastage of
factor inputs and higher costs
Big organizations often suffer from the debilitating effects of
internal politics, information over-load, complex bureaucracy,
unrealistic expectations among managers and cultural clashes
between senior people with inflated egos. The result can be that
hidden costs increase quickly – expense accounts, a slump in
productivity, a deadweight loss of time in slow-moving big
businesses. This is the essence of diseconomies of scale.
Avoiding diseconomies of scale
1. Human resource management (HRM) focuses on
improvements in recruitment, communication, training,
promotion, retention and support of faculty and staff. This
becomes critical to a business when the skilled workers it
needs are in short supply.
2. Performance related pay schemes (PRP) can provide
financial incentives for the workforce leading to an
improvement in industrial relations and higher
productivity. The John Lewis Partnership is often cited as
an example of how a business can empower its
employees by giving them a stake in the financial
success of the organization. Each partner gets a share of
the firm’s profits each year,
3. Out-sourcing is a tried and tested way of reducing costs
whilst retaining control over production although there
may be a price to pay in terms of the impact on the job
security of workers whose functions might be outsourced
overseas.
Fundamentally the best way to avoid diseconomies of scale is to
make business organization less complex and more transparent.
Nokia, diseconomies of scale and lost
competitive advantage
Nokia is a Finnish conglomerate business
that turned itself into the world’s leading
mobile phone company in the 1990s.
Nokia is profitable, but revenues are
under pressure and in 2010, Nokia
appointed a new CEO - Stephen Elop - to
drive strategic change
In February 2011 - Elop issued the famous
“burning platform” memo bluntly
explaining the strategic challenges facing
Nokia. Elop announced a strategic
partnership with Microsoft to jointly-
develop smart phones using the Windows
mobile platform - ditching Nokia’s
investment in its homegrown Symbian
platform
Nokia had missed the major change in its
market - the Smartphone revolution. It
had continued to focus on mobile phone
devices (hardware) rather than
applications (software). The consumer
transition from traditional mobile phones
to smart phones has been dramatic and
caught Nokia off-guard. According to Elop
"There is intense heat coming from our
competitors, more rapidly than we ever
expected. Apple disrupted the market by
redefining the Smartphone and attracting
developers to a closed, but powerful
ecosystem.”
Nokia has also faced intense competition
from mobile phone producers in emerging
markets who can make fast, cheap
handset. At the same time there was
recognition within the business that
diseconomies of scale were hurting its
competitiveness. Many in Nokia regretted
that the business had become too
product-led rather than customer-led. It
was felt that the business lacked
innovation with an overly-bureaucratic
organisational structure with poor
accountability.

Case Study: Amazon – Economies of Scale and Scope and Market Power
1. Increased dimensions: Firstly, the company invested in enormous warehouses to stock its
inventory of books, DVDs, computer peripherals. This allows it to benefit from the law of increased
dimension.
2. Buying power: Amazon has significant monopsony power when it purchases books directly from
publishers, thereby bypassing its reliance on wholesalers and giving it a higher profit margin.
3. Learning by doing and first-mover advantage: The unit costs of production tend to decline in real
terms as a result of production experience as businesses cut waste and find the most productive
means of producing output on a bigger scale
4. Pre-Orders - Amazon use a pre-order system for customers that allows it to capture early demand
and improve stock (or inventory) forecasting.
5. Less invested capital: As an online retailer, Amazon avoids the need for retail stores – one
advantage is that it has lower invested capital in the business and it frees up resources for customer
fulfillment and investment in new technology – Amazon distributes to over 200 countries.
6. Shifting stock at speed: Amazon has a much faster stock velocity – measured by the number of
weeks an item remains in stock. For Amazon this is half that of a physical store – and the benefit is a
reduction in obsolescence loss (the value of unsold stock is estimated to decline by 30% per year)
Economies of scale help to give Amazon a significant cost advantage. The business is also looking to
create economies of scope from marketing and broadening the range of products available through the
Amazon brand. Among the innovative business ideas under development we can identify:
 Merchants@/Marketplace which gives independent (third party) sellers the opportunity to sell their
products through the Amazon platform
 Amazon Enterprise Solutions – where Amazon provides e-commerce technology for a range of
partners such as Marks and Spencer, Lacoste, Mothercare and Timex
 Amazon Kindle – a portable reader that wirelessly downloads books, blogs, magazines and
newspapers to a high-resolution electronic paper display that looks and reads like real paper,
Amazon now sells nearly one fifth of the books bought in the UK each year.

8. Profits
The Nature of Profit
 Profit measures the return to risk when committing
scarce resources to a market or industry
 Entrepreneurs organise factors of production and take
risks for which they require an adequate rate of return.
 The higher the market risk and the longer they expect to
have to wait to earn a positive return, the greater will be
the minimum required return that an entrepreneur is
likely to demand
 Economists distinguish between different types of profit:
Normal profit
 Normal profit is the minimum profit required to keep
factors of production in their current use in the long run.
 Normal profits reflect the opportunity cost of using
funds to finance a business. If you put £200,000 of
savings into a new business, those funds could have
earned a low-risk rate of return by being saved in a bank
account. You might use the rate of interest on that
£200,000 as the minimum rate of return that you need to
make from your investment
 Because we treat normal profit as an opportunity cost
of investing financial capital in a business, we include an
estimate for normal profit in the average total cost curve,
thus, if the firm covers its AC then it is making normal
profits.
Sub-normal profit - profit less than normal (P < average cost)
Abnormal profit
 Any profit achieved in excess of normal profit - also
known as supernormal profit. When firms are making
abnormal profits, there is an incentive for other producers
to enter a market to try to acquire some of this profit.
 Abnormal profit persists in the long run in imperfectly
competitive markets such as oligopoly and monopoly
where firms successfully block the entry of new firms
Calculating Economic Profit
The data below is for an owner-managed firm for a given year
 Total revenue £320,000
 Raw material costs £30,000
 Wages and salaries £85,000
 Interest paid on bank loan £30,000
 Salary the owner could have earned elsewhere £32,000
 Interest forgone on capital invested £20,000
In a simple accounting sense, the business has total revenue of
Spotify reaches the Break-Even Point
Founded in 2006 and launched in 2008,
it has taken five years for online music
business Spotify to travel from the
point of concept to break-even. Spotify
has grown using the “Freemium” model
whereby a user-base is built by offering
a basic service for free. Revenues are
then built by offering paid-for premium
services to customers.
With Spotify, users can register either
for free accounts supported by
advertising or for paid subscriptions
without ads and with a range of extra
features such as higher bit rate streams
and offline access to music. A paid
“Premium” subscription is required to
use Spotify on mobile devices.
BSkyB Announces Record Profits
BSkyB has announced record revenues
and profits. Total revenue in the last
year grew by 7% to reach £7,235m and
operating profit was 9% higher at
£1,330m. This gave the business an
operating margin of 18.4% and helped
the business to generate free cash flow
of just over £1 billion. Revenue per
subscriber increased by £29 to £577.
BSkyB has 11.2 million customers.
Programming costs were 34% of sales
revenue at £2,486m. Sky paid £59m in
the last year for the right to offer live
coverage of the Ryder Cup, the Lions
Tour and Formula 1. It has also
invested more than £55m this year in
original comedy and drama.

£320,000 and costs of £145,000 giving an accounting profit of £175,000. But profit according to an
economist should take into account the opportunity cost of the capital invested and the income that the
owner could have earned elsewhere. Taking these two items into account we find that the economic profit is
£123,000.
Accounting Profit and Economic Profit
Short Run Profit Maximisation
Profits are maximised when marginal revenue = marginal cost
Price Per Unit (AR)
(£)
Demand /
Output
(units)
Total
Revenue (TR)
(£)
Marginal
Revenue (MR)
(£)
Total
Cost (TC)
(£)
Marginal
Cost (MC)
(£)
Profit
(£)
50 33 1650 2000 -350
48 39 1872 37 2120 20 -248
46 45 2070 33 2222 17 -152
44 51 2244 29 2312 15 -68
42 57 2394 25 2384 12 10
40 63 2520 21 2444 10 76
38 69 2622 17 2480 6 142
36 75 2700 13 2534 9 166
34 81 2754 9 2612 13 142
Consider the example in the table above. As price per unit declines, so demand expands. Total revenue
rises but at a decreasing rate as shown by the column showing marginal revenue. Initially the firm is making
a loss because total cost exceeds total revenue. The firm moves into profit at an output level of 57 units.
Thereafter profit is increasing because the marginal revenue from selling units is greater than the marginal
cost of producing them. Consider the rise in output from 69 to 75 units. The MR is £13 per unit, whereas
marginal cost is £9 per unit. Profits increase from £142 to £166.
But once marginal cost is greater than marginal revenue, total profits are falling. Indeed the firm makes
a loss if it increases output to 93 units.
Accounting Profit
Accounting Cost
Total
Revenue
Economic Profit =
abnormal Profit
Normal Profit =
Opportunity Cost
Accounting Cost
Economic
Cost

Showing profit maximisation in a diagram – the importance of marginal revenue and marginal cost
As long as marginal revenue > marginal cost, total profits will be increasing (or losses decreasing). The profit
maximisation output occurs when marginal revenue = marginal cost.
In the next diagram we introduce average revenue and average cost curves into the diagram so that, having
found the profit maximising output (where MR=MC), we can then find (i) the profit maximising price (using
the demand curve) and then (ii) the cost per unit.
 The difference between price and average cost marks the profit margin per unit of output.
 Total profit is shown by the shaded area and equals the profit margin multiplied by output
Profits are
decreasing when
MR < MC
Marginal Revenue
Marginal Cost
Q1
Revenue
And Cost
Output (Q)
Profits are
increasing
when MR > MC
Marginal profit: the
increase in profit when
one more unit is sold or
the difference between
MR and MC
Costs
Revenue
Output (Q)
AR
(Demand)
MR
SRMC
Q1
P1
AC1
Supernormal profits at
Price P1 and output Q1
AC2
Q2
Normal profit at Q2 where
AR = AC
SRAC

The Short Run Supply Decision - The Shut-down Price
A business needs to make at least normal profit in the long run to justify remaining in an industry but in the
short run a firm will continue to produce as long as total revenue covers total variable costs or price per
unit > or equal to average variable cost (AR = AVC). This is called the short-run shutdown price.
The reason for this is as follows. A business’s fixed costs must be paid regardless of the level of output. If we
make an assumption that these costs cannot be recovered if the firm shuts down then the loss per unit would
be greater if the firm were to shut down, provided variable costs are covered.
 Average revenue (AR) and marginal revenue curves (MR) lies below average cost, so whatever
output produced, the business faces making a loss
 At P1 and Q1 (where marginal revenue equals marginal cost), the firm would shut down as price is
less than AVC. The loss per unit of producing is distance AC. No contribution is made to fixed costs
 If the firm shuts down production the loss per unit will equal the fixed cost per unit AB.
 In the short-run, provided that the price is greater than or equal to P2, the business can justify
continuing to produce
 In the long run the shut down price is where AVC=P because all cost are variable
Recession and factory closures
 The concept of the shutdown point has become topical due to the recession and the weak
subsequent recovery
 Many businesses have opted to close down loss-making production plants and retailers have
announced the closure of retail outlets in a bid to cut their losses.
 Some of the plant closures have been temporary, for example some high-profile car manufacturers
mothballed their factories and reduced the number of shifts. But for other businesses, the downturn
brought about an end to trading. We have seen the demise of a large number of well-known retail
businesses.
Costs,
Revenues
Output (Q)Q1
MC
AVC
AR
MR
P1
AC1
A
B
C
P1 is below average variable cost
- staying in production means that
losses would increase.
P2
ATC

Blockbuster goes bust
The US parent company of the Blockbuster rental company has gone into bankruptcy.
In the early days of the internet, it was thought that a High Street presence was important to complement trading
via the internet.
But Blockbuster has gone, and so have Barnes and Noble. Meanwhile, Love Film and Amazon continue to grow at
a rapid rate. So a place on the High Street can’t be essential. Is it even desirable?
Blockbuster might yet last a while in the UK (where it continues as a franchise set up). But in the US the business
was trapped by two competitors. One force is the online competitor Netflix and the other was Redbox which rents
films for one dollar a night through kiosks in convenience stores.
Netflix has a vast selection of DVDs and is promoting the online streaming of older films, which subscribers will
increasingly be able to obtain through internet-connected television sets. Redbox, in contrast, focuses on big films
and recently-released DVDs which it rents out from vending machines for $1.
Blockbuster was crushed in the middle.
Source: Tom White, Tutor2u
Analysis: Deriving the Firm’s Supply Curve in the Short Run
1. In the short run, the supply curve for a business operating in a competitive market is the marginal
cost curve above average variable cost.
2. In the long run, a firm must make a normal profit, so when price = average cost, this is the break-
even point. It will therefore shut down at any price below this in the long run.
3. As a result the long run supply curve will be the marginal cost curve above average total cost.
The concept of a ‘supply curve’ is inappropriate when dealing with monopoly because a monopoly is a price-
maker, not a “passive” price-taker, and can thus select the price and output combination on the demand
curve so as to maximise profits where marginal revenue = marginal cost.
Analysis: Using Diagrams to show the effects of Changes in Demand and Supply Conditions
 A change in demand and/or costs will lead to a change in the profit maximising price and output.
 In exams you may often be asked to analyse how changes in demand and costs affect the
equilibrium output for a business. Make sure that you are confident in drawing these diagrams and
you can produce them quickly and accurately under exam conditions.
 In the diagram below we see the effects of an outward shift of demand from AR1 to AR2 short run
costs of production remain unchanged). The increase in demand causes a rise in the price from P1
to P2 (consumers are now willing and able to buy more at a given price) and an expansion of supply
(the shift in AR and MR is a signal to firms to move along their marginal cost curve and raise output).
Total profits have increased

A2 Micro Business Economics

Recomendados

Recomendados

Mais conteúdo relacionado

Mais procurados

Mais procurados (20)

Destaque

Destaque (7)

Semelhante a A2 Micro Business Economics

Semelhante a A2 Micro Business Economics (20)

Mais de tutor2u

Mais de tutor2u (20)

Último

Último (20)

A2 Micro Business Economics