Firms

syllabus guide

▪ Classification of firms -In terms of primary/secondary/tertiary sectors and private/public sector, and the relative size of firms.
▪ small firms-The advantages and disadvantages of small firms, the challenges facing small firms and reasons for their existence.
▪ causes and forms of the growth of firms-Internal growth, for example increased market share. External growth, for example mergers.
▪ mergers-Examples, advantages and disadvantages of different types of mergers: horizontal, vertical, and conglomerate
▪ economies and diseconomies of scale-How internal and external economies and diseconomies of scale can affect a firm/industry as the
scale of production changes.
Classification of firms
Firms can be classified according to:
1. Economic sectors - Primary , Secondary and Tertiary. (Refer to topic economic sectors )
o Primary sector -Extractive industry - example : Fishing , mining , agriculture
o Secondary sector- manufacturing and construction- example : factories
o Tertiary sector- services sector- banking , education , transport.
2. Public and private sectors
o Public sector firms are owned by the government with aim of providing a service and maximising social welfare.
o Private sector firms are owned by private individuals and owners with aim of profit maximisation. (Example: sole trader ,
partnership , company)
3. Relative size of firms - Firms can be classified according to size through the following ways :
Number of A small firm may employ less than 50 people For example, Mc Donalds is a large firm
employees employing more than 375000 people worldwide.

Market share Measures firm's sales revenue as a percentage of the For example : Google is the market leader in search
total market revenue. Smaller firms have smaller engines. Coca- Cola is the largest manufactures of
market share. soft drinks.
Market Measured by number of shares multiply by the current By market capitalisation , Apple , Google ,
capitalisation share price. Microsoft and facebook are among the largest
companies in USA
Value of output Measured by unit price multiply by quantity sold. For example: Walmart is the world's largest retailer
and sales. Large firms sell more compared to smaller firms. with annual sales of around $500b.

Small firms
Advantages of small firms Disadvantages of small firms
o Few legal formalities to set up. o Limited capital and finance to expand the business- Owners
have low savings and banks may not be willing to lend to small
firms.
o Lower start up costs. o No access to research and development which results in less
innovation.
o Close customer contact which allows firms to adapt according o Lower access to use of new technology which can be costly
to customer demand and ensure customer satisfaction compared to large firms.
o Easier to manage and control - No diseconomies of scale as o Do not reap economies of scale which results in higher unit
compared to large firms. costs and lower profits. compared to large firms.
J19 P22 N5c Analyse the reasons why small shops may be easy to set up. [6]
They do not take much money to set up (1) costs initially will be low (1)low fixed costs (1) it may be possible to borrow the money (1)
or use savings (1).
There may be government subsidies (1) designed to encourage the growth of small firms/shops / lower costs of production (1).
Running a small shop does not require significant management skills (1) people do not need a high level of education to run a small
shop (1).
May be less paperwork involved / regulations (1) reducing time and effort (1).

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 Challenges of small firms
o Lack of finance/difficulty raising finance (1) banks may be more reluctant to lend to small firms (1).
o May not be able to take advantage of economies of scale (1) may have higher average cost (1).
o Not well known (1) difficult to attract consumers (1).
o May face fierce competition from large firms (1) which may lower their prices/spend more on advertising (1).
o Risk of failure (1) due to inexperience of owners (1).
J20 P21 N3b Explain two challenges facing small firms. [4]

Reasons for existence of small firms / Why do firms remain small ?

o Adapts quickly to consumer taste and offer personalised products- For example clothes and furniture can be tailor-made and
adjusted.
o credit facilities are provided to customers.
o Convenient location in a remote area- especially for children and elderly.
o Some markets are small in size and so are the firms in it. For example : hairdresser , jeweller.
o Owners can easily manage the firm with no diseconomies of scale.
o Government may provide subsidies and grants to small firms.
o Difficult for small firms to raise capital for expansion- Low owner's saving and banks are reluctant to lend to them.

N14 P2 Q5 Discuss whether it is likely that the majority of small firms in an economy will remain small.
Up to 4 marks for stating that it is likely that the majority Up to 4 marks for stating that it is unlikely that the majority of
of small firms in an economy will remain small: small firms in an economy will remain small:
Up to 2 marks: the small size of a market (1) will keep the Up to 2 marks: small firms may benefit from becoming larger (1),
level of demand low, so that firms will necessarily need to such as benefiting from such economies of scale as technical and
be small (1). administrative economies (1).
Up to 2 marks: small firms can provide components for Up to 2 marks: if a small firm grew very large and became a
larger businesses (1), such as in the car industry, where small multinational company, it could benefit from lower costs (1) in
firms can be more flexible (1). different parts of the world (1).
Up to 2 marks: the owners may prefer to run a small firm (1) Up to 2 marks: it might make sense if there was just one firm in a
because they fear they do not have the expertise to run a market to avoid wasteful competition and duplication (1), such as
large firm and do not wish to share decision-making (1). with the existence of a natural monopoly (1).
Up to 2 marks: some firms specialise in different forms of Up to 2 marks: the market may be extremely large (1), meaning that
personal services (1) and it is much better if this personal a large firm might benefit from marketing economies of scale (1).
attention to detail is dealt with by a small firm (1). Up to 2 marks: if there are mergers and acquisitions, this will enable
Up to 2 marks: it may be difficult for a small firm to raise larger firms to be created (1) and smaller firms will then be squeezed
the necessary funds (1) to finance expansion (1). out (1).
Up to 2 marks: small firms may receive support by the
government (1), firms may be dependent on subsidies (1).
Up to 2 marks: to avoid diseconomies of scale (1), wishing
to keep average costs of production low/examples (1).

J13P1Q21 (Answer D)In a city, both large and small shops Nov11 P1Q19 (Answer D) Mr Jones runs a small shop selling
sell clothes.Why do large and small shops exist together? household appliances. His total revenue has declined due to the
A Large clothing shops create barriers to entry. opening of a large supermarket which sells a similar range of
B Small shops always sell clothes at lower prices. goods. How could Mr Jones compete with the supermarket?
C The market for clothing operates under perfect A develop financial economies of scale
competition. B engage in a price-cutting war
D There is demand from consumers for a range of fashions. C introduce a massive advertising campaign
D provide personal after-sales service

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 Growth of firms
Firms can grow internally or externally.

➢ Internal growth/Organic growth- This is where firms expand using their own resources by ploughing back profits or bringing
additional capital. They can invest in new products /sell more of existing ones/ increase the number of branches/make use of e-
commerce/franchise their business.
Benefit of internal growth : Owners may keep control of their business.
Example : Coca Cola has grown internally by expanding around the world and it now sells its drinks in all but two countries in the
world-North Korea and Cuba.

➢ External growth/Inorganic growth-This involves expanding through another organisation such as mergers and takeovers.
• A merger occurs when two or more firms join together to form one firm.
• A takeover is where a firm gains control or acquires part of another firm, with or without agreement.
Benefit of external growth : More rapid expansion and the business may gain more knowledge and expertise
Example : Microsoft bought Skype in 2011.
Mergers / Integration

There are 3 main types of mergers- Horizontal , Vertical and Conglomerate.

• Horizontal merger- when two firms at the same stage of production and in the same industry joins together.
Example : A car manufacturer merging with another car manufacturer

Advantages Disadvantages
Lower competition as number of firms decrease which can Each firm has different management style which can create
lead higher profits and sales. disagreements and conflicts.
Larger production scale which can lead to economies to The firm may have higher market power and act like a
scale. This lowers average cost and price. monopoly. It may charge higher prices, exploiting
consumers.
Firms may experience diseconomies of scale which
increases average costs and price to consumers.

J2016 P2 Q6d Discuss whether consumers benefit from horizontal mergers. [8]
• A horizontal merger is a merger between two firms at the same stage of production producing the same product (1).
Up to 5 marks for why it might:
• They may enable the firms to take greater advantage of economies of scale (1) example (1) this will reduce average cost of production
(1) this may lower prices to consumers (1).
• They may enable the firms to earn more profit (1) which they can spend on research and development (1) increasing innovation (1)
raising the quality of the product (1).
Up to 5 marks for why it might not:
• They may result in the firms experiencing diseconomies of scale (1) example (1) this will increase average cost of production (1) this
may raise prices to consumers (1).
• The firms may gain greater market share (1) move it closer to monopoly (1) this may result in higher prices (1).
• Vertical merger- When two firms in the same industry but at different stage of production joins together.
o Vertical forward integration- When a firm in the same industry joins another in the next stage of production.
Example : A car manufacturer merging with a car showroom.
o Vertical backward integration- When a firm in the same industry joins another in the previous stage of production.
Example : A car manufacturer merging with a tyre manufacturer.
Advantages Disadvantages
Backward- Less reliance on suppliers as raw materials can Each firm has different management style which can create
be easily available. disagreements and conflicts.
Forward- Easy availability of outlets to sell the products.
The firm may reap economies of scale due to large scale Diseconomies of scale may arise which increases average
production with lower costs and lower price. cost.

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 • Conglomerate /lateral merger -When two firms in different industries merge together.
Example : A car manufacturer joining with a textile firm.
Advantages Disadvantages
There is diversification which reduces risk of business Poor decision making if the managers fail to understand the
failure. Losses in one sector can be offset by profits in operations of the other industry.
another.
Business may make better use of finance which can be Each firm has different management style which can create
invested in the industry having better prospect and growth. disagreements and conflicts.

J17P1Q12 (Answer D) To achieve horizontal integration, a J16P1Q13 (Answer A) Two firms agree to integrate their
firm producing tyres could merge with another firm producing activities. What must result?
A motor cars. A a change in their ownership structure
B rubber. B a lowering of average costs of production
C tyre-producing machinery. C a move from national to international markets
D tyres. D a reduction in the level of market risk
N14P1Q12 (Answer A) N13P1Q19 (Answer B)
A large tyre manufacturer expands by taking over a rubber To achieve horizontal integration a record company producing
plantation. Of what is this an example? compact discs (CDs) could merge with another firm. What
A backward vertical integration would this firm most likely be doing?
B diversifying integration A owning shops selling CDs
C forward vertical integration B producing CDs
D horizontal integration C producing CD players
D producing machinery used in the making of CDs

N14P2Q5c Using examples, distinguish between vertical, horizontal and conglomerate integration. [5]
Up to 2 marks: vertical integration is the joining of two firms at different stages of production in the same industry (1) e.g. a tea
company taking over a tea plantation (1), or forward vertical integration, forwards towards consumers (later stage of production), e.g.
a brewery taking over a public house (1).
Up to 2 marks: horizontal integration joins together firms at the same stage of production, e.g. two banks (1).
Up to 2 marks: conglomerate integration joins together firms in different areas of activity to spread interests and risks over different
industries (1), e.g. the Indian company Tata which produces motor vehicles and tea (1).

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 Economies and diseconomies of scale
As a large grows in size(produces more output and on a larger scale) , it reaps economies of scale which results in a fall in average
cost. EOS relates to the advantages of large scale production.
A large firm producing on large scale may also obtain diseconomies of scale which leads to a rise in average cost.

Initially , as the firm increases output , its average costs fall (

economies of scale) up to the minimum point at Q*. After this
point, if the firm increases output, average costs will rise
(diseconomies of scale).

Economies and diseconomies of scale can be divided in terms of internal and external.

Internal economies of scale

This refers to a fall in average costs due to the growth of the firm itself. The internal economies of scale are :
Technical economies: large firms can purchase expensive specialist equipment and invest in new technology which makes the
firm more productive.
Purchasing economies (Or bulk buying): buying in large quantities will enable a firm to negotiate bulk discounts with suppliers
leading to a lower cost per unit.
Financial economies: Larger firms are able to borrow money from banks more easily and at lower rates of interest and have a
greater range of sources for new capital such as the issuing of shares.
Managerial economies: larger firms can afford to employ specialist staff in areas such as finance, marketing, and production.
Marketing economies: larger firms are able to use more expensive marketing methods as the cost can be spread across more units
of output thereby lowering cost per unit.
Risk-bearing economies: larger firms are able to spread risk by offering a range of products. If one product loses sales, then it can
still rely on the others to remain profitable thereby minimizing losses.

External economies of scale

This refers to a fall in average cost which arises from the growth of the size of the industry.
Education and training facilities: a local university’s research and development facilities can provide help to all
firms.
Concentration of firms: if suppliers of parts locate near the main producer this cut transport costs and time taken.

Transport: if transport links are improved such as better roads, faster rails travel and deeper ports, then the costs
of transport fall.
Finance: if there is a concentration of an industry in an area then banks will develop specialist facilities for these
firms.
Location: certain areas get a reputation for an industry, for example Silicon Valley in California. This attracts
support firms, which benefits all firms in the industry.

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 Internal diseconomies of scale
This refers to an increase in average costs which arises from the growth of the firm.
Managerial - Managers find it difficult to coordinate production.
Communication- There may be inefficient communication due to tall hierarchies and many workers being employed. This can
delay decision making.
Motivation- Workers may feel cut off from decision making and thus feel alienated and de-motivated.

External diseconomies of scale.

This refers to an increase in average costs which result from the growth of the industry.
Overconcentration of firms in an area which can lead to congested roads and transport delays in delivering goods as well as higher
demand for labour resulting in higher wages.

J18 P1 Q13 (Answer A) .

What is a possible cause of diseconomies of scale?

A an increase in extra administration

B an increase in raw materials costs
C an increase in taxation on company profits
D an increase in the national minimum wage

June 2012 P2Q5c Distinguish between internal and external economies of scale.
Internal economies of scale:
• reductions in long-term average costs as the scale of production and output of the firm increases, e.g. marketing, administrative,
technical, risk-bearing and financial economies.
External economies of scale:
• falls in long-run average costs for a firm when the industry in which the firm operates grows in size, e.g. availability of skilled labour,
ancillary firms, infrastructure.
J2016 P2 Q4c Analyse two internal diseconomies of scale that a large firm may experience. [6]
• Difficulties controlling/managing the firm/managerial diseconomies (1) there are more layers of management in a large firm (1) may
take longer to make decisions (1).
• Communication problems (1) there are more layers of communication/communication may be indirect (1) messages may be
misinterpreted/take time to reach recipients (1).
• Labour diseconomies (1) Workers may feel less appreciated/have low morale (1) so may become de-motivated (1) which could reduce
labour productivity/efficiency (1).
• Poor industrial relations (1) industrial action e.g. strikes may occur (1) due to the time it takes to address workers’ grievances (1)
more people to argue with (1).
J14 P2Q4bExplain two types of internal economy of scale that a growing bank can enjoy. [4]
1 mark each for two types identified e.g.: managerial, financial, technical, risk bearing.
1 mark each for explanations of the two types identified linked to banking e.g.
• a larger bank may be able to employ specialist workers such as accountants
• a larger bank may be able to sell its shares more easily and/or borrow more easily from other banks
• a larger bank may be able to use advanced technology and large scale capital equipment
• a larger bank may be able to offer a range of financial services so if one is unsuccessful, it will not have a significant impact on
profits.