Recht und Ökonomie. Law & Economics. (3) Business Economics. LVA-Nr.: SS 2015

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1 Prof. Dr. Friedrich Schneider Institut für Volkswirtschaftslehre Recht und Ökonomie (Law and Economics) LVA-Nr.: SS 2015 (3) Business Economics SS 2015 Law & Economics 1 / 41

2 Content (1-2) (1) The Growth of Firms Internal Growth External Growth External: Vertical Integration External: Horizontal Integration External: Conglomerate Acquisition Motives for Growth (2) Ownership and Control (3) Economic Issues Diminishing Returns Efficiency Basic Concept Productive Arrangements Technical Requirements Allocative Efficiency Social Costs & Efficiency SS 2015 Law & Economics 2 / 41

3 Content (2-2) (4) Motives of Firms Profit Maximisation Other Objectives of Firms Behavioural Objectives (5) Competition Distinction Perfectly Competitive Markets Imperfect Competition Imperfect Competition: Monopoly Imperfect Competition: Oligopoly SS 2015 Law & Economics 3 / 41

4 1. The Growth of Firms 1.1. Internal Growth Growth of firms internal or external Internal Growth Internal growth generated through increasing sales. To increase sales firms need to: market effectively; invest in new equipment & capital; and / or invest in labour (e.g. training). SS 2015 Law & Economics 4 / 41

5 External growth through: 1. The Growth of Firms 1.2. External Growth Amalgamation [ Verschmelzung ] Agreed fusion of one or more firms to a new legal entity (A+B C). Merger [ Fusion ] Agreed fusion, one of the combining companies survives as a legal entity. Takeover (acquisitions) One firm is seeking control over another company: o Could be friendly or hostile. SS 2015 Law & Economics 5 / 41

6 1. The Growth of Firms 1.2. External Growth (cont.) External growth three types of acquisition: (1) Vertical Integration (2) Horizontal Integration (3) Conglomerate acquisition [ Mischkonzern-Übernahme ] Vertical Integration Vertical integration: Amalgamation, merger or takeover at different stages of the productive process. SS 2015 Law & Economics 6 / 41

7 1. The Growth of Firms External: Vertical Integration (cont.) Primary Vertical Integration BACKWARDS acquisition takes place towards the source. Secondary Manufacturer Tertiary Retail Stores SS 2015 Law & Economics 7 / 41

8 1. The Growth of Firms External: Vertical Integration (cont.) Primary Secondary Dairy Farming Cooperative Cheese Processing Plant Vertical Integration FORWARDS acquisition takes place towards the market. Tertiary SS 2015 Law & Economics 8 / 41

9 1. The Growth of Firms Horizontal Int. / Conglomerate Acq External: Horizontal Integration Horizontal integration: Amalgamation, merger or takeover at the same stage of the productive process External: Conglomerate Acquisition Conglomerate acquisition [ Mischkonzern-Übernahme ] : Amalgamation, merger or takeover of firms in different lines of business. SS 2015 Law & Economics 9 / 41

10 1. The Growth of Firms External: Horizontal Integration (cont.) Primary Horizontal Integration Secondary Confectionery Manufacturer Soft Drinks Manufacturer Tertiary SS 2015 Law & Economics 10 / 41

11 1. The Growth of Firms 1.3. Motives for Growth Motives for growth Cost Savings External growth may be cheaper than internal growth acquiring an underperforming or young firm may represent a cost effective method of growth examples new economy: Apple (Siri), Facebook (Instagram), Google (Nest). Managerial Rewards External growth may satisfy managerial objectives power, influence, status. SS 2015 Law & Economics 11 / 41

12 1. The Growth of Firms 1.3. Motives for Growth (cont.) Shareholder Value Improve the value of the overall business for shareholders. Asset Stripping Selling off valuable parts of the business. Economies of Scale [ Größenvorteile ] The advantages of large scale production that lead to lower unit costs. Efficiency [ Effizienz ] Improve technical, productive / allocative efficiency. SS 2015 Law & Economics 12 / 41

13 Synergy 1. The Growth of Firms 1.3. Motives for Growth (cont.) The whole is more efficient than the sum of the parts (2 + 2 = 5!). Control of Markets Gain some form of monopoly power [ Monopolmacht ]. Control supply. Secure outlets [ Absatzmärkte ]. Risk Bearing [ Risikotragfähigkeit ] Diversification to spread risks. SS 2015 Law & Economics 13 / 41

14 2. Ownership and Control Firm Separation between ownership and control who runs the business? Shareholders [ Aktionäre, Anteilseigner, Gesellschafter ]? Board of Directors [ Vorstand, Verwaltungsrat ]? SS 2015 Law & Economics 14 / 41

15 2. Ownership and Control (cont.) Principal-Agent Relationship [ Prinzipal-Agent Beziehung ] : Shareholders act as principals [ Prinzipale ], Board as agents [ Agenten ] principals expect agents to act in their interest. Subcontracting work operates on a similar basis (employer = principal; employee = agent). Problem: Principal cannot perfectly observe performance [ Leistung, Erfüllung ] of agent information asymmetry! Solution: Contracts and compensation procedures to ensure that agents act on behalf of principals. SS 2015 Law & Economics 15 / 41

16 3. Economic Issues 3.1. Diminishing Returns Law of Diminishing Returns [ Gesetz abnehmender Erträge ] : 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 [ Skalenerträge ] : increasing, constant or diminishing. SS 2015 Law & Economics 16 / 41

17 3. Economic Issues 3.1. Diminishing Returns (cont.) Example diminishing returns [ abnehmende Erträge ] : 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 ( see graph next slide). SS 2015 Law & Economics 17 / 41

18 3.1. Diminishing Returns (cont.) Graphical representation Output Total Product (TP) Quantity of the variable factor SS 2015 Law & Economics 18 / 41

19 3.2. Efficiency Basic Concept Efficiency in production is reached when: One can not produce the same level of output [ Output- Niveau, -Menge ] at lower costs; i.e. using the minimal amount of resources valued at their (factor) prices; or one can not produce more output using the same set / amount of inputs. SS 2015 Law & Economics 19 / 41

20 Lowest Costs: 3.2. Efficiency Productive Arrangements Productive efficiency is not yet achieved when the same output could be produced at lower total costs. Can be achieved through re-organization (e.g. cell production [ Inselfertigung ]), investment in new technology, training for staff, SS 2015 Law & Economics 20 / 41

21 Minimum inputs: 3.2. Efficiency Technical Requirements Technical efficiency is not yet achieved if the same output can be produced using fewer inputs. Can be achieved by using labor saving devices, more efficient machinery, more effective reorganization / restructuring, SS 2015 Law & Economics 21 / 41

22 3.2. Efficiency Allocative Efficiency Needs of consumers are almost unlimited. BUT resources for production of goods / services are clearly limited (e.g. commodities [ Rohstoffe] ). Result: Limited supply & almost unlimited demand. Option for balancing supply & demand market mechanism P = MC. P price of good / service (paid by consumer). MC marginal costs [ Grenzkosten ] of good / service = production costs for one further unit. SS 2015 Law & Economics 22 / 41

23 3.2. Efficiency Allocative Efficiency (cont.) Allocative efficiency [ Allokationseffizienz ] occurs where the (amount of) goods and services being produced match the demand by consumers. If P = MC the value placed on the good / service by the buyer (= the paid price) equals the costs of the resources used to generate the good / service. SS 2015 Law & Economics 23 / 41

24 Social costs: 3.2. Efficiency Social Costs & Efficiency An actor (business firm, individual, etc.) initiating an action does not necessarily bear all the costs or reap all the benefits of that action. Those costs that the actor does bear are the private costs; those costs that the actor does NOT bear are the external costs ( have no influence on decisions of actor!). Sum of these two costs = social costs. SS 2015 Law & Economics 24 / 41

25 3.2. Efficiency Social Costs & Efficiency (cont.) Any constrained [ eingeschränktes ] optimum can be viewed as a situation where marginal costs (MC) equal marginal benefit [ Grenznutzen ] (MB) MC = MB. Society social optimum: MSC = MSB MSC: Marginal Social Costs [ gesellschaftliche Grenzkosten ]; MSB: Marginal Social Benefit [ gesellschaftlicher Grenznutzen ]. SS 2015 Law & Economics 25 / 41

26 3.2. Efficiency Social Costs & Efficiency (cont.) Social efficiency [ gesellschaftliche Effizienz ] occurs where the private and social costs of production are equal to the private and social benefit derived from consumption of production important: external costs & benefit included! Is a measure of social welfare [ gesellschaftliche Wohlfahrt ]. SS 2015 Law & Economics 26 / 41

27 4. Motives of Firms 4.1. Profit Maximisation The firms objective is profit maximization [ Gewinnmaximierung ]. Profit maximization implies cost minimization [ Kostenminimierung ]. BUT: Firms are constrained by the technology at any given point in time. Hence, the main task of a firm is the optimal combination of inputs (labour, capital, commodities). SS 2015 Law & Economics 27 / 41

28 4. Motives of Firms 4.1. Profit Maximisation (cont.) Profit (π) is defined as the difference between total revenue and total costs. Total costs = fixed costs + variable costs. Profit maximisation is assumed to be the standard motive of firms in the private sector. SS 2015 Law & Economics 28 / 41

29 4. Motives of Firms 4.1. Profit Maximisation (cont.) A firm will maximize its profits by producing at an output level where marginal costs (MC) are equal to marginal revenue (MR) [ Grenzerlös ] MC = MR. Firm will continue to increase output up to the point where the costs of producing one extra unit of output equal the revenue received from selling that last unit of output. This assumes that firms seek to operate at maximum efficiency. SS 2015 Law & Economics 29 / 41

30 4. Motives of Firms 4.2. Other Objectives of Firms Other objectives sales maximisation: Attempts to maximise the volume of sales ( market share) rather than the revenue gained from them. Share Price [ Aktienkurs ] Maximisation: Pursuing policies aimed at increasing the share price. Profit Satisficing [ Profiterwartungen zufriedenstellen ] : Generating sufficient profits to satisfy shareholders but maximising the rewards to the managers / board; and avoiding attention from rivals (could enter market) or national regulatory authorities (prices too high?). SS 2015 Law & Economics 30 / 41

31 4. Motives of Firms 4.3. Behavioural Objectives Modern firms have to attempt to match competing stakeholder needs stakeholder of a firm: Shareholders. Employees. Consumers. Suppliers [ Lieferanten ]. Government. Local communities ( firm = local employer & taxpayer). Environment. SS 2015 Law & Economics 31 / 41

32 4. Motives of Firms 4.3. Behavioural Objectives (cont.) Firms may have to balance out their responsibilities: Management rewards / bonuses, etc. Social and environmental audits. Employee welfare. Meeting consumer needs. Paying suppliers [ Lieferanten ] on time. Satisfying shareholders. SS 2015 Law & Economics 32 / 41

33 5. Competition 5.1. Distinction Competition between firms in a market fundamental distinction: Market with perfect competition [ vollkommener Wettbewerb ]. Market with imperfect competition [ unvollkommener / unvollständiger Wettbewerb ]. SS 2015 Law & Economics 33 / 41

34 5. Competition 5.2. Perfectly Competitive Markets Perfect competition [ vollkommener Wettbewerb ] : Many firms competing with each other in a market. Implies that no individual actor can influence the market price firms = price taker [ Preisnehmer ]. Products are perfect substitutes for consumers. Firms may have positive or negative profits in the short run. Leads to zero economic profits for each firm in the long run. Will result in a Pareto-optimal allocation of resources in the long run. SS 2015 Law & Economics 34 / 41

35 5. Competition 5.3. Imperfect Competition Imperfect competition [ unvollkommener / unvollständiger Wettbewerb ] different characteristics. Monopoly [ Monopol ] : Just one supplier (firm) in a market. Monopolistic competition [ Monopolistischer Wettbewerb ] : Many firms in a market; BUT differentiated products no perfect substitutes for customers. Oligopoly [ Oligopol ] : Only a few firms in a market action of one firm will be noticed by the other firm(s) the other firm(s) will react. SS 2015 Law & Economics 35 / 41

36 Other forms: 5. Competition 5.3. Imperfect Competition (cont.) Cartels [ Kartelle ] : o A group of similar, independent firms; they fix prices, limit production, share markets or customers between them. Price leadership [ Preisführerschaft ] : o Prices are largely determined by a single firm, other firms adjust their prices afterward. Dominant firm(s). SS 2015 Law & Economics 36 / 41

37 5. Competition 5.3. Imperfect Competition (cont.) Other forms [continued]: Spatial competition [ räumlicher Wettbewerb ] : o Consumers & firms are dispersed over a geographic (spatial) environment each firm faces somewhat separable geographic markets price discrimination [ Preisdiskriminierung ] is possible. Bilateral monopoly [ bilaterales Monopol ] : o Only one seller and only one buyer in a market (e.g. defence industry & state). SS 2015 Law & Economics 37 / 41

38 5. Competition Imperfect Competition: Monopoly Monopoly [ Monopol ] : Just one supplier [ Anbieter ] (firm) in a market. The monopolist faces the market demand curve. A monopolist maximizes profit by producing a quantity where Marginal Costs (MC) = Marginal Revenue (MR). Monopoly price (P) [ Monopolpreis ] than MC of monopolist. will be higher SS 2015 Law & Economics 38 / 41

39 5. Competition Imperfect C.: Monopoly (cont.) Monopoly [continued]: The monopoly price [ Monopolpreis ] the price under perfect competition. will be higher than The monopoly quantity [ Monopolmenge ] will be lower than the quantity under perfect competition Creates a so-called deadweight loss = loss of welfare [ Wohlfahrtsverlust ]. o Welfare = consumer surplus [ Konsumentenrente ] + producer surplus [ Produzentenrente ]. SS 2015 Law & Economics 39 / 41

40 5. Competition Imperfect Competition: Oligopoly Oligopoly [ Oligopol ] : Characterized by a small number of firms. Consequence: Action of one firm will be noticed by the other firm(s) the other firm(s) will react. Example: Cournot model two firms decide (simultaneously) how much to produce, treating the other firm s output as given. SS 2015 Law & Economics 40 / 41

41 References Reference [chapter (1) - (4)]: Ashwin, Andrew (2006), Business Economics, SS 2015 Law & Economics 41 / 41

MICROECONOMIC FOUNDATIONS OF COST-BENEFIT ANALYSIS. Townley, Chapter 4

MICROECONOMIC FOUNDATIONS OF COST-BENEFIT ANALYSIS Townley, Chapter 4 Review of Basic Microeconomics Slides cover the following topics from textbook: Input markets. Decision making on the margin. Pricing