Prof. Dr. Friedrich Schneider Institut für Volkswirtschaftslehre Recht und Ökonomie (Law and Economics) LVA-Nr.: WS 2012/13 (3) Business Economics WS 2012/13 Law and Economics 1 of 28

Content (1)The growth of firms. (2)Key issues. (3)Efficiency. (4)Motives of firms. (5)Competition. Source chapter (1) - (4): WS 2012/13Law and Economics2 of 28

1. The Growth of Firms 1.1. Internal Growth Growth of firms  internal or external Internal Growth:  Generated through increasing sales.  To increase sales firms need to:  Market effectively.  Invest in new equipment and capital.  Invest in labour. WS 2012/13Law and Economics3 of 28

1. The Growth of Firms 1.2. External Growth 1.2. External Growth:  Through:  amalgamation,  merger, or  takeover (acquisitions).  Mergers  agreed amalgamation between two firms.  Takeover  One firm seeking control over another:  Could be “friendly” or “hostile”. WS 2012/13Law and Economics4 of 28

1. The Growth of Firms 1.2. External Growth (cont.) External growth – three types of acquisition: (1)Vertical Integration (2)Horizontal Integration (3)Conglomerate Merger Vertical Integration:  Amalgamation, merger or takeover at different stages of the productive process. WS 2012/13Law and Economics5 of 28

1. The Growth of Firms External: Vertical Integration WS 2012/13Law and Economics6 of 28 Primary Secondary Tertiary Retail Stores Manufacturer Vertical Integration BACKWARDS – acquisition takes place towards the source.

Primary Secondary Tertiary Dairy Farming Cooperative Cheese Processing Plant Vertical Integration FORWARDS – acquisition takes place towards the market. 1. The Growth of Firms External: Vertical Integration (cont.) WS 2012/13Law and Economics7 of 28

1. The Growth of Firms External: Horizontal Integration Horizontal Integration:  Amalgamation, merger or takeover at the same stage of the productive process WS 2012/13Law and Economics8 of 28

Primary Secondary Tertiary Soft Drinks Manufacturer Confectionery Manufacturer 1. The Growth of Firms External: Horizontal Integration (cont.) WS 2012/13Law and Economics9 of 28

1. The Growth of Firms External: Conglomerate Acquisition Conglomerate Acquisition:  Amalgamation, merger or takeover of firms in different lines of business. WS 2012/13Law and Economics10 of 28

1. The Growth of Firms 1.3. Motives  Cost Savings  External growth may be cheaper than internal growth - acquiring an underperforming or young firm may represent a cost effective method of growth.  Managerial Rewards  External growth may satisfy managerial objectives - power, influence, status  Shareholder Value  Improve the value of the overall business for shareholders.  Asset Stripping  Selling off valuable parts of the business.  Economies of Scale  The advantages of large scale production that lead to lower unit costs. WS 2012/13Law and Economics11 of 28

1. The Growth of Firms 1.3. Motives (cont.)  Efficiency  Improve technical, productive or allocative efficiency.  Synergy  The whole is more efficient than the sum of the parts (2 + 2 = 5!).  Control of Markets  Gain some form of monopoly power.  Control supply.  Secure outlets.  Risk Bearing –Diversification to spread risks. WS 2012/13Law and Economics12 of 28

2. Key Issues 2.1. Ownership and Control  Separation between ownership and control – who runs the business?  Shareholders?  Board of Directors?  Principal-Agent Relationship:  Shareholders act as principals, Board as agents – principals expect agents to act in their interest.  Sub-contracting work operates on a similar basis (employer = principal; employee = agent)  Contracts and compensation procedures to ensure agents act on behalf of principals. WS 2012/13Law and Economics13 of 28

2. Key Issues 2.2. Diminishing Returns  Law of Diminishing Returns:  Increasing successive units of a variable factor to a fixed factor will increase output but eventually the addition to output will start to slow down and would eventually become negative.  To prevent diminishing returns setting in, all factors need to be increased  returns to scale (increasing, constant or diminishing). WS 2012/13Law and Economics14 of 28

2. Key Issues 2.2. Diminishing Returns (cont.) Diminishing Returns: Assume, the amount of land/plant was fixed. Adding labour and capital units would initially increase output but the rate at which output would rise will start to decline and eventually would become negative unless the amount of land/plant was increased to accommodate the increase in variable factors. WS 2012/13Law and Economics15 of 28

2.2. Diminishing Returns (cont.) – Graphical representation Output Quantity of the variable factor Total Product (TP) WS 2012/13Law and Economics16 of 28

3. Efficiency 3.1. Basic Concept  Efficiency in production will be reached when:  one cannot produce the same level of output at lower cost, i. e. using the minimal resources, valued at their (factor) prices; or  one cannot produce more output using the same set of inputs. WS 2012/13Law and Economics17 of 28

3. Efficiency 3.2. Productive Arrangements  Lowest Cost:  Productive efficiency can be achieved where the same output could be produced at lower total cost.  Achieved through re-organisation (e.g. to cell production), investment in new technology, training for staff and so on. WS 2012/13Law and Economics18 of 28

3. Efficiency 3.3. Technical Requirements  Minimum inputs:  Technical efficiency can be achieved if the same output can be produced using fewer inputs.  Can be achieved using labour saving devices, more efficient machinery, more effective re-organisation of restructuring and so on. WS 2012/13Law and Economics19 of 28

3. Efficiency 3.4. Allocative Efficiency  Needs of Consumers  market mechanism  P = MC.  P … price of good / service.  MC … marginal costs of good / service (= production cost for one further unit).  Allocative efficiency occurs where the goods and services being produced match the demand by consumers.  P = MC  the value placed on the product by the buyer (the price) equals the cost of the resources used to generate the good / service. WS 2012/13Law and Economics20 of 28

3. Efficiency 3.5. Social Efficiency  Any constrained optimum can be viewed as a situation where marginal cost (MC) equals marginal benefit (MB)  MC = MB.  MSC = MSB  MSC … Marginal Social Costs.  MSB … Marginal Social Benefit.  Social efficiency occurs where the private and social cost of production is equal to the private and social benefits derived from their consumption.  A measure of social welfare. WS 2012/13Law and Economics21 of 28

4. Motives of Firms 4.1. Profit Maximisation  The firms’ objective is profit maximization.  Profit maximization implies cost minimization.  Firms are constrained by the technology at any given point in time.  The main task of a firm is the optimal combination of inputs.  Profit (π) is defined as the difference between total revenue and total cost. WS 2012/13Law and Economics22 of 28

4. Motives of Firms 4.1. Profit Maximisation (cont.)  Profit maximisation: assumed to be the standard motive of firms in the private sector.  A firm will maximize its profits by producing at an output level where marginal cost (MC) is equal to marginal revenue (MR)  MC = MR.  The firm will continue to increase output up to the point where the cost of producing one extra unit of output equals the revenue received from selling that last unit of output.  This assumes that firms seek to operate at maximum efficiency.  For a firm operating in a perfectly competitive market: MR will be equal to P  above condition (MC = MR) becomes to MC = P. WS 2012/13Law and Economics23 of 28

4. Motives of Firms 4.2. Other Objectives of Firms  Sales maximisation:  Attempts to maximise the volume of sales rather than the revenue gained from them.  Share Price Maximisation:  Pursuing policies aimed at increasing the share price.  Profit Satisficing:  Generating sufficient profits to satisfy shareholders but maximising the rewards to the managers / board and avoiding attention from rivals or regulatory authorities. WS 2012/13Law and Economics24 of 28

4. Motives of Firms 4.3. Behavioural Objectives  Modern firms have to attempt to match competing stakeholder needs:  Shareholders.  Employees.  Consumers.  Suppliers.  Government.  Local communities.  Environment. WS 2012/13Law and Economics25 of 28

4. Motives of Firms 4.3. Behavioural Objectives (cont.)  Firms may have to balance out their responsibilities:  ‘Fat cat pay’ ( Bezahlung Top-Manager ).  Management rewards – bonuses, etc.  Social and environmental audits.  Employee welfare.  Meeting consumer needs.  Paying suppliers on time.  Satisfying shareholders about its policies, plans and actions. WS 2012/13Law and Economics26 of 28

5. Competition 5.1. Perfectly competitive markets  Perfect competition: –implies that no individual actor can influence the market price; –firms may have positive or negative profits in the short run; –leads to zero profits for each firm in the long run; –will result in a Pareto optimal allocation of resources in the long run. WS 2012/13Law and Economics27 of 28

5. Competition 5.2. Imperfect competition  Monopoly:  Just one supplier (firm) in a market.  The Price (quantity) will be higher (lower) than the price (quantity) under perfect competition  “deadweight loss” (= lower welfare).  Monopolistic competition:  Many firms with differentiated products.  Oligopoly:  Only a few firms (2, 4, …?) in a market  action of one firm will be noticed by the other firm(s)  other firm(s) will react.  Other forms, e. g. cartels, price leadership, spatial competition, … WS 2012/13Law and Economics28 of 28