Teory of consumer behaviour
5.0 Introduction
Consumer behaviour is concerned with the way individuals or consumers behave when faced with the problem of scarcity. That is, it assesses how individuals try to maximise their levels of satisfaction using limited resources that they have at their disposal. The theory is the basis of explaining the law of demand, that is, why the demand curve is downward sloping or why people buy more at a lower price than a higher price. In this chapter we are going to outline the two approaches to consumer behaviour, namely cardinalistapproach (marginal utility theory) and theordinalist approach (indifference curve analysis). A downward sloping demand curve will be constructed using each approach as an illustration of why the demand curve slopes downward from left to right.
5.1 The marginal utility theory of demand
5.1.1. Assumptions
a) Utility can be measured using cardinal numbers. A consumer can be said to derive 10 utils of satisfaction from the first drink, 8utils from the second and so on. As a result the theory is also referred to as the cardinalist approach to consumer behaviour.
b) The consumer is rational, that is, the consumer would want to maximise total utility, given the level of prices and income. This eliminates monomania which is behaviour when a consumer spends all his income on one product. A rational consumer will seek to spread his income over a variety of products in a manner that gives him the greatest amount of satisfaction.
5.1.2. Definitions
Utility is the satisfaction people get from consuming (using) a good or a service. It is subjective that is it depends on the consumer. For example, one consumer may derive satisfaction from smoking a cigarette while another person can develop a headache from cigarette smoke. Utility also differs with situations. An ice cold glass of water can be more satisfying when it is very hot but the same glass of water may yield less satisfaction when it is very cold.
• Total utility is the sum of the utilities derived from all units consumed.
• Marginal utility is the additional satisfaction people get from consuming an extra unit of a good. Marginal utility declines as more and more units of the same commodity are consumed. This is the law of diminishing marginal utility.The law of diminishing marginal utility states that as more and more units of the same commodity are consumed, a consumer derives less satisfaction from an additional unit of the commodity consumed than the previous unit.
Following is a table and graph of the utilities an individual derives from drinking Coca-Cola at a birthday party.
Table 5.1 Total utility and marginal utility
Quantity Consumed
|
Total Utility
|
Marginal Utility
| |
0
|
0
|
-
| |
1
|
10
|
10
| |
2
|
16
|
6
| |
3
|
20
|
4
| |
4
|
22
|
2
| |
5
|
22
|
0
| |
6
|
20
|
-2
| |
The relationship between total utility and marginal utility as consumption increases can be reflected on the following diagram.
Fig 5.1 The relationship between total utility and marginal utility
Utility
5.1.3. The Utility Maximising Combination of Goods
The consumer who aims to maximise his utility will arrange his expenditure so that he derives the same utility from the last dollar spent on each good. This is ordinarily referred to as “value for money” in everyday language. This is achieved when ratio of the MU of the last unit consumed to the price of one good is equal to the same ratio of another good.
MUA= MUB PA PB
This is the principle of equi-marginal utility
Example
Consider a woman with a budget of $100 and wants to spend it on apples (A) and bananas (B). The price of an apple is $20 and that of a banana is $10. If the woman’s preferences are given in the table, the utility maximising combination of apples and bananas that exhaust her budget can be obtained as follows:
Table 5.2 Utilities derived from the consumption of bananas and apples
Quantity of Apples
|
MUA
|
MUA
PA=20
|
MUA
PA=10
|
Quantity of Bananas
|
MUB
|
MUB
PB= 10
| ||||||
1
|
100
|
5
|
10
|
4
|
40
|
4
| ||||||
2
|
60
|
3
|
6
|
5
|
35
|
3.5
| ||||||
3
|
40
|
2
|
4
|
6
|
30
|
3
| ||||||
4
|
30
|
1.5
|
3
|
7
|
20
|
2
| ||||||
5
|
20
|
1
|
2
|
8
|
10
|
1
| ||||||
6
|
10
|
0.5
|
1
|
9
|
0
|
0
| ||||||
The woman would consume 2 apples and 6 bananas if the price of an apple is $20 and that of a banana is $10. If the price of an apple is reduced to $10, the woman would increase her consumption of apples from 2 apples to 4 apples, while her expenditure on bananas is constant.
The woman’s expenditure on apples at the two prices can be represented on the demand schedule and curve.
Table 5.3 Demand schedule for the woman
Price of Apples
|
Quantity Demanded
|
20
|
2
|
10
|
4
|
Fig 5.2 Demand curve for the woman
Price of apple
O Q1 =2 Q2 = 4
The demand schedule and curve shows the amount of a good one or more consumers are willing and able to buy at different prices.
5.2. The indifference curve analysis
In the 1930’s, a group of economists came to believe that cardinal measurement of utility was not necessary. Consumer behaviour could be explained using ordinal numbers. This is because individuals are able to rank their preferences into first, second, third and so on. They preferred an ordinalist approach to measurement of satisfaction. As a result, this theory of consumer behaviour is also referred to as the ordinalist approach to consumer behaviour.
5.2.1 Indifference curves: What is preferred.
An indifferent curve represents all combinations or bundles of two commodities that yield the same amount of satisfaction to the consumer. The consumer derives the same amount of satisfaction from combinations of the two commodities along an indifference curve. In this way, the consumer will be ‘indifferent’ between these combinations. That is, the consumer can not prefer one combination to another simply because he gets the same amount of satisfaction. He can have any of those combinations on the curve.
Assumptions
a) The consumer buys only two goods, X and Y.
b) The consumer is rational, that is, given an income and a set of prices the consumer would aim to maximise total utility.
c) The consumer is consistent and transitive in his choice. Given three bundles of commodities X and Y and the consumer prefers bundle A to B, there will be no time when the same consumer will prefer B to A (consistency). If the consumer prefers bundle A to B and B to C, the same consumer will prefer bundle A to C (transitivity).
d) The consumer always prefermore of a commodity to less (more is better).
Fig 5.3 An indiffence curve
Indifference Curve
O Y1 Y2 Quantity of good Y
Quantity o
The consumer derives the same utility from consuming bundle A or B. As a result he is indifferent between the two bundles A and B. indifference curves have the following characteristics:
a) They slope downward from left to right.
b) They are convex to the origin.
c) The slope of an indifference curve measures the rate of exchange of X for Y along the curve (marginal rate of substitution). As more units of good X are exchanged for additional units of good Y the consumer will prefer to have a greater amount of good Y to compensate for each unit of good X traded.
d) Different indifference curves constructed on the same plane gives what is known as an indifference map. On an indifference map, indifference curves to the right entails a higher level of utility and are preferable. They represent higher combinations of the two goods and hence more is better.
e) Indifference curves do not cross each other.
5.2.2 The Budget line: What Is Attainable
A budget line shows all the combinations of two commodities which can be purchased with a given money income. Assuming that a consumer must spend all of his income on one or two goods X and Y, it will be evident that
QxPx + QyPy = Income where: -
Qx= amount of good X the consumer buysQy= amount of good Y the consumer buys
Px = price of good X
Py = price of good Y
This is an equation of a straight line, which can be represented by the following graph.
Fig 5.4 The budget line
Qty of good X
O Quantity of good Y
Points outside the budget line, that is, points to the right of the boundary represent combinations of the two goods that are not affordable given the consumer’ s income. On the other hand, points inside the boundary are attainable but the consumer will not be spending all his income. Only points along the boundary represent combinations of the two goods when the consumer is spending all his income. Thus the location of the budget line varies with money income and price levels. Any changes in money income and or prices will change the position of the budget line.
A change in money income will shift the budget line while a change in price of one good will pivot the budget line while it remains anchored on the axis of the good whose price is held constant as illustrated below.
Fig 5.5
a) Increase in Income
O Quantity of Y O Quantity of Y
5.2.3. The Equilibrium of the Consumer
Not all preferred bundles are attainable. Equilibrium will be at the point where the budget line is tangent to the highest attainable indifference curve
Fig 5.6 Consumer equilibrium
O Ye Quantity of Good Y
Consumer equilibrium is at point E where Ye units of good Y and Xe units of good X are consumed. At point E the budget line is tangent to the indifference curve IC2
5.6.3. The derivation of the demand curve
A fall in the price of good Y from PA to PBwill cause the budget line to pivot outward (to the right). Tangency of the budget line will change from being tangent to indifference curve IC2 to tangent to indifference curve IC3. Consumer equilibrium will change from point E to E1indicating that quantity demanded of good Y will increase from Ye to Y1.
Fig 5.7 Derivation of a downward sloping demand curve
O Ye Y1 Quantity of Good Y
Following the fall in the price of good Y, the quantity demanded of good Y has increased from Ye to Y1. This implies an inverse relationship between price and quantity demanded.
Theory of consumer behaviour
5.0 Introduction
Consumer behaviour is concerned with the way individuals or consumers behave when faced with the problem of scarcity. That is, it assesses how individuals try to maximise their levels of satisfaction using limited resources that they have at their disposal. The theory is the basis of explaining the law of demand, that is, why the demand curve is downward sloping or why people buy more at a lower price than a higher price. In this chapter we are going to outline the two approaches to consumer behaviour, namely cardinalistapproach (marginal utility theory) and theordinalist approach (indifference curve analysis). A downward sloping demand curve will be constructed using each approach as an illustration of why the demand curve slopes downward from left to right.
5.1 The marginal utility theory of demand
5.1.1. Assumptions
a) Utility can be measured using cardinal numbers. A consumer can be said to derive 10 utils of satisfaction from the first drink, 8utils from the second and so on. As a result the theory is also referred to as the cardinalist approach to consumer behaviour.
b) The consumer is rational, that is, the consumer would want to maximise total utility, given the level of prices and income. This eliminates monomania which is behaviour when a consumer spends all his income on one product. A rational consumer will seek to spread his income over a variety of products in a manner that gives him the greatest amount of satisfaction.
5.1.2. Definitions
Utility is the satisfaction people get from consuming (using) a good or a service. It is subjective that is it depends on the consumer. For example, one consumer may derive satisfaction from smoking a cigarette while another person can develop a headache from cigarette smoke. Utility also differs with situations. An ice cold glass of water can be more satisfying when it is very hot but the same glass of water may yield less satisfaction when it is very cold.
• Total utility is the sum of the utilities derived from all units consumed.
• Marginal utility is the additional satisfaction people get from consuming an extra unit of a good. Marginal utility declines as more and more units of the same commodity are consumed. This is the law of diminishing marginal utility.The law of diminishing marginal utility states that as more and more units of the same commodity are consumed, a consumer derives less satisfaction from an additional unit of the commodity consumed than the previous unit.
Following is a table and graph of the utilities an individual derives from drinking Coca-Cola at a birthday party.
Table 5.1 Total utility and marginal utility
Quantity Consumed
|
Total Utility
|
Marginal Utility
| |
0
|
0
|
-
| |
1
|
10
|
10
| |
2
|
16
|
6
| |
3
|
20
|
4
| |
4
|
22
|
2
| |
5
|
22
|
0
| |
6
|
20
|
-2
| |
The relationship between total utility and marginal utility as consumption increases can be reflected on the following diagram.
Fig 5.1 The relationship between total utility and marginal utility
Utility
5.1.3. The Utility Maximising Combination of Goods
The consumer who aims to maximise his utility will arrange his expenditure so that he derives the same utility from the last dollar spent on each good. This is ordinarily referred to as “value for money” in everyday language. This is achieved when ratio of the MU of the last unit consumed to the price of one good is equal to the same ratio of another good.
MUA= MUB PA PB
This is the principle of equi-marginal utility
Example
Consider a woman with a budget of $100 and wants to spend it on apples (A) and bananas (B). The price of an apple is $20 and that of a banana is $10. If the woman’s preferences are given in the table, the utility maximising combination of apples and bananas that exhaust her budget can be obtained as follows:
Table 5.2 Utilities derived from the consumption of bananas and applesQqqw
Quantity
Quantity
of Apples
|
MUA
|
MUA
PA=20
|
MUA
PA=10
|
Quantity of Bananas
|
MUB
|
MUB
PB= 10
| ||||||
1
|
100
|
5
|
10
|
4
|
40
|
4
| ||||||
2
|
60
|
3
|
6
|
5
|
35
|
3.5
| ||||||
3
|
40
|
2
|
4
|
6
|
30
|
3
| ||||||
4
|
30
|
1.5
|
3
|
7
|
20
|
2
| ||||||
5
|
20
|
1
|
2
|
8
|
10
|
1
| ||||||
6
|
10
|
0.5
|
1
|
9
|
0
|
0
| ||||||
The woman would consume 2 apples and 6 bananas if the price of an apple is $20 and that of a banana is $10. If the price of an apple is reduced to $10, the woman would increase her consumption of apples from 2 apples to 4 apples, while her expenditure on bananas is constant.
The woman’s expenditure on apples at the two prices can be represented on the demand schedule and curve.
Table 5.3 Demand schedule for the woman
Price of Apples
|
Quantity Demanded
|
20
|
2
|
10
|
4
|
Fig 5.2 Demand curve for the woman
Price of apple
O Q1 =2 Q2 = 4
The demand schedule and curve shows the amount of a good one or more consumers are willing and able to buy at different prices.
5.2. The indifference curve analysis
In the 1930’s, a group of economists came to believe that cardinal measurement of utility was not necessary. Consumer behaviour could be explained using ordinal numbers. This is because individuals are able to rank their preferences into first, second, third and so on. They preferred an ordinalist approach to measurement of satisfaction. As a result, this theory of consumer behaviour is also referred to as the ordinalist approach to consumer behaviour.
5.2.1 Indifference curves: What is preferred.
An indifferent curve represents all combinations or bundles of two commodities that yield the same amount of satisfaction to the consumer. The consumer derives the same amount of satisfaction from combinations of the two commodities along an indifference curve. In this way, the consumer will be ‘indifferent’ between these combinations. That is, the consumer can not prefer one combination to another simply because he gets the same amount of satisfaction. He can have any of those combinations on the curve.
Assumptions
a) The consumer buys only two goods, X and Y.
b) The consumer is rational, that is, given an income and a set of prices the consumer would aim to maximise total utility.
c) The consumer is consistent and transitive in his choice. Given three bundles of commodities X and Y and the consumer prefers bundle A to B, there will be no time when the same consumer will prefer B to A (consistency). If the consumer prefers bundle A to B and B to C, the same consumer will prefer bundle A to C (transitivity).
d) The consumer always prefermore of a commodity to less (more is better).
Fig 5.3 An indiffence curve
Indifference Curve
O Y1 Y2 Quantity of good Y
Quantity o
The consumer derives the same utility from consuming bundle A or B. As a result he is indifferent between the two bundles A and B. indifference curves have the following characteristics:
a) They slope downward from left to right.
b) They are convex to the origin.
c) The slope of an indifference curve measures the rate of exchange of X for Y along the curve (marginal rate of substitution). As more units of good X are exchanged for additional units of good Y the consumer will prefer to have a greater amount of good Y to compensate for each unit of good X traded.
d) Different indifference curves constructed on the same plane gives what is known as an indifference map. On an indifference map, indifference curves to the right entails a higher level of utility and are preferable. They represent higher combinations of the two goods and hence more is better.
e) Indifference curves do not cross each other.
5.2.2 The Budget line: What Is Attainable
A budget line shows all the combinations of two commodities which can be purchased with a given money income. Assuming that a consumer must spend all of his income on one or two goods X and Y, it will be evident that
QxPx + QyPy = Income where: -
Qx= amount of good X the consumer buysQy= amount of good Y the consumer buys
Px = price of good X
Py = price of good Y
This is an equation of a straight line, which can be represented by the following graph.
Fig 5.4 The budget line
Qty of good X
O Quantity of good Y
Points outside the budget line, that is, points to the right of the boundary represent combinations of the two goods that are not affordable given the consumer’ s income. On the other hand, points inside the boundary are attainable but the consumer will not be spending all his income. Only points along the boundary represent combinations of the two goods when the consumer is spending all his income. Thus the location of the budget line varies with money income and price levels. Any changes in money income and or prices will change the position of the budget line.
A change in money income will shift the budget line while a change in price of one good will pivot the budget line while it remains anchored on the axis of the good whose price is held constant as illustrated below.
Fig 5.5
a) Increase in Income
O Quantity of Y O Quantity of Y
5.2.3. The Equilibrium of the Consumer
Not all preferred bundles are attainable. Equilibrium will be at the point where the budget line is tangent to the highest attainable indifference curve
Fig 5.6 Consumer equilibrium
O Ye Quantity of Good Y
Consumer equilibrium is at point E where Ye units of good Y and Xe units of good X are consumed. At point E the budget line is tangent to the indifference curve IC2
5.6.3. The derivation of the demand curve
A fall in the price of good Y from PA to PBwill cause the budget line to pivot outward (to the right). Tangency of the budget line will change from being tangent to indifference curve IC2 to tangent to indifference curve IC3. Consumer equilibrium will change from point E to E1indicating that quantity demanded of good Y will increase from Ye to Y1.
Fig 5.7 Derivation of a downward sloping demand curve
O Ye Y1 Quantity of Good Y
Following the fall in the price of good Y, the quantity demanded of good Y has increasede from Ye to Y1. This implies an inverse relationship between price and quantity demanded.
8
Theory of production
6.0 Introduction
In these remaining sections of microeconomics we are going to examine the behaviour of firms when allocating their scarce resources towards alternative uses. What is a firm? Put briefly, a firm is a unit that produce a good or service for sale. Economists generally assume that firms attempt to maximize profits. However, firms may have alternative objectives such as sales maximization; the provision of a service e.g. sports clubs and, establishing a status quo.
6.1 Production defined
Production is the process during which factors of production are combined and transformed into goods and services. It is the result of making use of the resources (always in relatively limited supply) available to man for the purpose of supplying him with goods and services for the satisfaction of his needs and wants.
6.2 Factors of production
Anything, which plays a part in production and makes a contribution to the final product, is a factor of production. Factors of production are:
(a) Land which refers to all the resources of nature or anything that if God given. "By land is mean the material and the forces which nature gives freely for man's aid, in land and water, air and light and heat", Alfred Marshall.
(b) Labour is all human effort whether of hand or mind, which is undertaken for a reward.
(c) Capital is all goods, other than land which is used in the production of other goods. Capital is a result of past labour and for this reason; it is sometimes referred to as "crystallized labour".
(d) Organisation or entrepreneurship involves the skill and effort put into the running of a firm. It embodies the acceptance of risks that arise because of uncertainty.
6.3 Variable and fixed factor inputs
In production, factors of production are the inputs. Input is defined as anything that a firm uses in its production process. Inputs can be divided into two categories: fixed inputs and variable inputs. A fixed input is an input whose quantity cannot be changed during the period of time under consideration. The firm's plant and equipment are examples of fixed inputs. On the other hand, a variable input is an input whose quantity can be changed during the relevant period e.g. raw materials, labour and energy.
6.4 Short run and long run production periods
Whether or not an input is regarded as variable or fixed depends on the length of the period under consideration. The longer the period, the more inputs are variable, not fixed. Economists focus on two time period: the short run and the long run. The short run is defined to be that period of time which some of the firm's inputs are fixed. More specifically, it is the period of time in which a firm must consider some inputs absolutely fixed in making its decisions. Therefore in the short run, firms can only increase output by increasing the input of variable factors. On the other hand, the long run is that period of time in which all inputs are variable. In the long run, the firm can make a complete adjustment to any change in its environment. Thus in the long run, a firm can consider all of its inputs to be variable when making its decisions.
6.5 Production in the short run
In the short run, the production decision is constrained by the fact that at least one input is fixed in supply while the other inputs can be varied. By definition, in the short run, the firm can change its output by adding variable resources to a fixed plant. But how does output change as more and more variable inputs are added to a fixed factor? The answer is provided by the law of diminishing marginal returns.
6.5.1 The law of diminishing marginal returns
The law describes what happens to total output when more units of the variable factors are added to a given quantity of the fixed factor. It states that 'if increasing quantities of one factor of production which is variable are used in conjunction with a quantity of other factors which are fixed, after a certain point is reached each successive unit of the variable factor added to the whole will make a smaller and smaller contribution to the total product". Put very briefly, this law simply states that 'as successive units of a variable resource e.g. labour are added to a fixed resource e.g. land, beyond some point, the extra or additional product (output) contributed by each additional unit of the variable resource will decline, that is, the marginal product will diminish.
Example
The following table summarises the output from the employment of labour on a fixed piece of land. It illustrates that beyond 3 units of labour, the marginal product of labour decreases, that is, diminishing marginal returns set in after the third unit of labour is employed. Table 6.1 TP, AP and MP
Inputs of variable factor –
(Labour)
|
Total Product
(TP)
|
Average Product (AP)
|
Marginal Product (MP)
|
0
|
0.00
|
-
|
-
|
1
|
6.00
|
6.00
|
6.00
|
2
|
13.50
|
6.75
|
7.50
|
3
|
21.00
|
7.00
|
7.50
|
4
|
28.00
|
7.00
|
7.00
|
5
|
34.00
|
6.80
|
6.00
|
6
|
38.00
|
6.30
|
4.00
|
7
|
38.00
|
5.40
|
0.00
|
8
|
37.00
|
4.60
|
-1.00
|
The average product (AP) of an input is total product divided by the amount of the input used to produce this amount of output. That is average product is output per unit of the variable factor (in this case, called labour productivity).
The marginal product of an input is the addition to total output due to the addition of the last unit of the input, when the amounts of other inputs used are held constant. Marginal product shows the change in total output associated with each additional input of labour.
The relationship between total product and amount of labour used on a piece of land in the above table can be shown on the following graph.
Fig 6.1 The total product curve
Total Product
Amount of Labour
The diagram shows that, as a variable factor (labour) is added to fixed amounts of the fixed factor (land) the resulting total product will eventually increase by diminishing amounts, reach a maximum and then decline.
From the previous table, it can be noted that marginal product exceeds average product when the latter is increasing, equals average product when the latter reaches a maximum, and is less than average product when the latter is decreasing. This is simply a matter of arithmetic: If the addition to a total is greater (less) than the average, the average is bound to increase (decrease). This relationship can be illustrated in the following graph.
8
7
6 5
3
2
1
The marginal product intersects average product at the maximum average product. When average product is increasing, marginal product is greater than average product. When average is decreasing, marginal product is less than average. When average product is at a maximum, marginal product equals average product.
“If diminishing returns do not occur, the world could be fed out of a flowerpot” McConnel and Brue. Several things should be noted concerning the law of diminishing marginal returns.
(a) The law is an empirical generalization, not a deduction from physical or biological laws.
(b) It is assumed that technology remains fixed. The law of diminishing marginal returns cannot predict the effect of an additional unit of input when technology is allowed to change.
(c) It is assumed that there is at least one input whose quantity is being held constant. The law of diminishing marginal returns does not apply to cases where there is a proportional increase in all inputs. That is it only applies in the short run.
(d) The law assumes that all units of variable inputs are of equal quality. Therefore marginal product ultimately diminishes not because successive units of the variable input are incompetent but because more of the variable input is being used relative to the amount of fixed inputs available.
6.6 Production in the long run
We now consider the long run situation in which all inputs are variable. By definition long run is a variable plant time period. What will happen to output if the firm increases the amount of all input by the same proportion? This is an important question, the answer to which help to determine whether firms of certain sizes can survive in the industry. In other words, long run decisions are important because today's variable factors are tomorrow's equipped plant will have many alternatives from which to choose, but once installed the capital is fixed for a long time. If the firm errs now, its very survival may be threatened.
6.6.1 Returns to scale
To repeat, what will happen to output if the firm increases the amount of all inputs by the same proportion? Clearly, there are three possibilities: -
(a) Output my increase by a larger proportion than each of the inputs. For example, a doubling of all inputs may lead to more than a doubling of output. This is a case ofincreasing returns to scale.
(b) Output may increase by a smaller proportion than each of the inputs. For example a doubling of all inputs may lead to less than a doubling of output. This is the case of decreasing returns to scale.
(c) Output may increase by exactly the same proportion as the inputs. For example a doubling of all inputs may lead to a doubling of output. This is the case of constant returns to scale.
6.6.2 Economies and diseconomies of scale
The returns to scale can sometimes be identified as economies and diseconomies of scale. When a firm is experiencing increasing returns to scale, it is said to be enjoying economies of scale. While a firm experiencing decreasing returns to scale will be enjoying diseconomies of scale.
(a) Economies of scale
Economies of scale refer to the advantages of an increased plant size or benefits of producing on a larger scale. They exist when the expansion of a firm or industry allows the product to be produced at a lower average cost. Economies of scale occur within a firm (internal) or outside the firm as a result its location (external). Internal economies are those benefits obtained within a firm when it expands its capacity. On the other hand, external economies are those benefits gained when the industry as a whole expand. i. Internal economies of scale
These are made within a firm as a result of its expansion in production. As the firm produces more and more units of output, so average cost begin to fall because of:
Technical economiesmade in the actual production of the good e.g. large firms can use expensive machinery intensively.
Managerial economiesmade in the administration of a large firm by splitting up management jobs and employing specialist accountants, salesmen etc.
Financial economies made by borrowing money at lower rates of interest than smaller firms borrow.
Marketing economiesmade by spreading the high cost of advertising on television and in national newspapers, across a large level of output.
Commercial economiesmade when buying supplies in bulk and therefore receiving quantity discounts.
Research and development economies made when developing new and better products.
Risk bearing economiesmade when diversifying into different products and markets.
ii. External economies of scale
These are economies made outside the firm as a result of its location and occur when:
A local skilled labour force locates in the area.
An area develop good infrastructure e.g. roads and communications network.
Ancillary services can be provided e.g. banking, food courts etc
Subcontracting of specialist services e.g. photocopying
By-products can be used as inputs by other firms
b) Diseconomies of scale
There is an optimal level of expansion in the size of a firm or industry beyond which the firm will suffer diseconomies of scale as represented by a rise in its long run average costs. Diseconomies of scale refer to the increase in average cost that comes as a result of the firm producing on a large scale.
i. Internal diseconomies of scale
These occur when the firm has become too large and inefficient. As the firm increases production, eventually average costs begin to rise because: -
The disadvantages of the division of labour and specialisation such as increased boredom from repeating the same task may start to take effect.
Management becomes out of touch with the shop floor because of the enlarged work force and some machinery becomes over-manned.
Decisions are not taken quickly due to consulting and there is too much form filling.
Lack of communication or double communication in a large firm means that management tasks sometimes get done twice.
Poor labour relations may develop in large companies ( low morale of workers , that is, workers not feeling to be part of the organisation)
Dissatisfied customers due to poor customer service
ii. External Diseconomies of Scale
These occur when too many firms have located in one area. Unit costs begin to rise because: - Skilled labour becomes scarcer and firms have to offer higher wages to attract new workers.
Local roads become congested and so transport costs begin to rise (externalities).
High input prices as firms compete for the scarce inputs.
6.6.3. Economies of scale and returns to scale
In our discussion, we associated economies of scale to returns to scale. An advanced analysis would however make a distinction between the two. Economies of scale reduce the unit cost of production as the scale of production increases. Returns to scale are concerned with physical input and output relationships. Generally, increasing returns to scale should result in decreasing costs and decreasing returns to scale should result in increasing costs. Returns to scale refer to the long run physical output of factors of production or inputs. Conversely economies of scale refer to long run money costs of production. If physical output increases more than proportionately as the scale of all the inputs is changed, increasing returns to scale occur. Increasing returns to scale contribute to economies of scale (in the form of technical economies) but some economies of scale are not explained by increasing returns to scale e.g. commercial economies of scale.
6.7. Size and growth of firms
It is the objective of many firms to grow and expand their size or scale of operations. The major reason for this growth is the expansion of the market share which is directly related to profitability.
6.7.1. Ways of measuring the size of a firm
The size of a firm can be measured using at least one of the following indicators
a. Number of workers employed.
b. Capital employed.
c. Value of assets.
d. Market share.
e. Profit before tax.
f. Turnover or sales.
6.7.2. Reasons for the growth of firms
Large size leads to economies of scale which makes a firm more competitive and have better chances of survival through: - a. A large market share.
b. The firm can borrow money cheaply.
c. Goodwill.
d. Spreading risks.
e. Diversification.
f. Influencing government on issues relating to business through advocacy.
g. Directors may seek power and status that come from being in charge of a large firm.
6.7.3. Methods of growth of firms
Firms can either grow through internal expansion or external expansion
i. Internal expansion
Through internal expansion, a firm can grow through: -
a. Producing and selling more of its current products in its existing market.
b. Selling current products to new markets.
c. Making and selling new products.
However it may be important to note that internal expansion allows firms to grow rather slowly.
ii. External expansion or integration
Integration occurs when two firms join together to form one new company. Integration can be voluntary (a merger) or forced (a takeover). A merger takes place between companies through their agreement where they form a joint venture and benefit from shared production, research and development etc. On the other hand a take-over occurs when one company buys enough shares of voting to allow it to take control of the other company.
There are three types of integration namely vertical integration, horizontal integration and lateral integration.
a. Horizontal integrationoccurs between two firms in the same industry that are at the same stage of production e.g. the merger of First Merchant Bank, Bard Holdings and UDC into African Banking Corporation (ABC). The advantages are that the new company will enjoy economies of scale and have a larger market share.
b. Vertical integrationoccurs between companies in the same industry but which are at different stages of production. Vertical integration can either be backward or forward integration. Vertical backward integration occurs when a company starts to control firms supplying it with its raw materials, that is, moving back down the chain of production. For example, if BATA Shoe Company integrates with South East Leather Tanners, a leather tanning company in the Lowveld. Conversely, vertical forward integration occurs where a company merges or take-over firms further along the chain of production for example if BATA Shoe Company merges with Sole Trader, a shoe retail shop.
c. Lateral Integration or conglomerate occurs when firms in different industries merge. For example if BATA Shoe Company merges with Trust Academy, an educational institution. Conglomerates have advantages in reduced risks through diversification, good reputation and advocacy.
The three main types of integration: horizontal, vertical and lateral (conglomerate) are illustrated below
Vertical backward integration
(Sole Trader)
6.7.4. Motives for integration
Recently in Zimbabwe particularly in the banking sector most firms has horizontal integrated or at least made advances towards integration. There are a number of reasons why firms may decide to integrate. Among them:
a. Integration increases the size and market share of the firm e.g. First Bank Corporation and Zimbabwe Building Society into FBC Holdings.
b. One firm may need fewer workers, managers, or premises (rationalisation).
c. Reduce competition by removing rivals e.g. United Bottlers and Punch Bowel, which was producing RC Cola.
d. Integration allows firms to increase the range of products they manufacture (diversification) e.g. First Bank Corporation and Zimbabwe Reinsurance (ZIMRE) that led to the provision of banking and insurance products.
e. Reducing risk, that is, if the firm is diversified it no longer has “all its eggs in one basket”.
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