Classification of Firms
Firms can be classified in terms of the sectors they operate in and their relative sizes.
Firms are classified into the following three categories based on the type of operations undertaken by them:
- Primary: all economic activity involving extraction of raw natural materials. This includes agriculture, mining, fishing etc. In pre-modern times, most economic activity and employment was in this sector, mostly in the form of subsistence farming (farming for self-consumption).
- Secondary: all economic activity dealing with producing finished goods. This includes construction, manufacturing, utilities etc. This sector gained importance during the industrial revolution of the 19th and 20th centuries and still makes up a huge part of the modern economy.
- Tertiary: all economic activity offering intangible goods and services to consumers. This includes retail, leisure, transport, IT services, banking, communications etc. This sector is now the fastest-growing sector as consumer demand for services have increased in developed and developing nations.
Firms can also be classified on the basis of whether they are publicly owned or privately owned:
- Public: this includes all firms owned and run by the government. Usually, the defence, arms and nuclear industries of an economy are completely public. Public firms don’t have a profit motive, but aim to provide essential services to the economy it governs. Governments do also run their own schools, hospitals, postal services, electricity firms etc.
- Private: this includes all firms owned and run by private individuals. Private firms aim at making profits and so their products are those that are highly demanded in the economy.
Firms can also be classified on their relative size as small, medium or large depending on the output, market share, organisation (no. of departments and subsidiaries etc).
A small firm is an independently owned and operated enterprise that is limited in size and in revenue depending on the industry. They require relatively less capital, less workforce and less or no machinery. These businesses are ideally suited to operate on a small scale to serve a local community and to provide profits to the owners.
Advantages of small businesses:
- Independence: owner(s) are free to run the business as he/she pleases.
- Control: the owner(s) has full control over the business, unlike in a large business where multiple managers, departments and branches will exist.
- Flexibility: small businesses can adapt to quick changes as the owner is more involved in the decision-making.
- Better communication: since there are fewer employees, information can be intimated easily and quickly.
- Innovation: small businesses can tend to be innovative because they have less to lose and are willing to take risks.
Disadvantages of small businesses:
- Higher costs: small firms cannot exploit economies of scale – their average costs will be higher than larger rivals.
- Lack of finance: struggles to raise finance as choice of sources of acquiring finance is limited.
- Difficult to attract experienced employees: a small business may be unable to afford the wage and training required for skilled workers.
- Vulnerability: when economic conditions change, it is harder for small businesses to survive as they lack resources.
Small firms still exist in the economy for several reasons:
- Size of the market: when there is only a small market for a product, a firm will see no point in growing to a larger size. The market maybe small because:
- the market is local – for example, the local hairdresser.
- the final product maybe an expensive luxury item which only require small-scale production (e.g. custom-made paintings)
- personalised/custom services can only be given by small firms, unlike large firms that mostly give standardised services (e.g. wedding cake makers).
- Access to capital is limited, so owners can’t grow the firm.
- Owner(s) prefer to stay small: a lot of entrepreneurs don’t want to take risks by growing the firm and they are quite satisfied with running a small business.
- Small firms can co-operate: co-operation between small firms can lead them to set up jointly owned enterprises which allow them to enjoy many of the benefits that large firms have.
- Governments help small firms: governments usually provide help to small scale firms because small firms are an important provider of employment and generate innovation in the production process. In most countries, it is the medium and small industries that contribute much of the employment.
Growth of Firms
When a firm grows, its scale of production increases. Firms can grow in to ways: internally or externally.
Internal Growth/Organic Growth
This involves expanding the scale of production of the firm’s existing operations. This can be done by purchasing more machinery/equipment, opening more branches, selling new products, expanding business premises, employing more workers etc.
This involves two or more firms joining together to form a larger business. This is called integration. This can be done it two ways: mergers or takeovers.
A takeover or acquisition happens when a company buys enough shares of another firm that they can take full control. The firm taken over loses its identity and becomes a part of what is known as the holding company. A well-known example would be Facebook’s acquisition of Whatsapp in 2014.
A merger occurs when the owners of two or more companies agree to join together to form a firm.
Mergers can happen in three ways:
- Horizontal Integration: integration of firms engaged in the production of the same type of good at the same level of production. Example: a cloth manufacturing company merges with another cloth manufacturing company.
- Exploit internal economies of scale: including bulk-buying, technical economies, financial economies.
- Save costs: when merging, a lot of the duplicate assets including employees can be laid off.
- Potential to secure ‘revenue synergies’ by creating and selling a wider range of products.
- Reduces competition: by merging with key rivals, the two firms together can increase market share.
- Risk of diseconomies of scale: a larger business will bring with a lot of managerial and operational issues leading to higher costs.
- Reduced flexibility: the addition of more employees and processes means the need for more transparency and therefore more accountability and red tape, which can slow down the rate of innovating and producing new products and processes.
- Vertical Integration: integration of firms engaged in the production of the same type of good but at different levels of production (primary/secondary/tertiary). Example: a cloth manufacturing company (secondary sector) merges with a cotton growing firm (primary sector).
- Forward vertical integration: when a firm integrates with a firm that is at a later stage of production than theirs. Example: a dairy farm integrates with a cheese manufacturing company.
- Backward vertical integration: when a firm integrates with a firm that is at an earlier stage of production than theirs. Example: a chocolate retailer integrates with a chocolate manufacturing company.
- It can give a firm assured supplies or outlets for their products. If a coffee brand merged with coffee plantation, the manufacturers would get assured supplies of coffee beans from the plantation. If the coffee brand merged with a coffee shop chain, they would have a permanent outlet to sell their coffee from.
- Similarly, one firm can prevent the other firm from supplying materials or selling products to competitors. The coffee brand can have the coffee plantation to only supply them their coffee beans. The coffee brand can also have the coffee shop chain only selling coffee with their coffee powder.
- The profit margins of the merged firm can now be absorbed into the merging firm.
- The firms can increase their market share and become more competitive in the market.
- Risk of diseconomies of scale: a larger business will bring with a lot of managerial and operational issues leading to higher costs
- Reduced flexibility: the addition of more employees and processes means the need for more transparency and therefore more accountability and red tape, which can slow down the rate of innovating and producing new products and processes
- It’s a difficult process: The firms, when vertically integrated, are entering into a stage of production/sector they’re not familiar with, and this will require staff of either firm to be educated and trained. Some might even lose their jobs. It can be expensive as well.
- Lateral/Conglomerate integration: this occurs when firms producing different type of products integrate. They could be at the same or different stages of production. Example: a housing company integrates with a dairy farm. Thus, the firm can produce a wide range of products. This helps diversify a firm’s operations.
- Diversify risks: conglomerate integration allows businesses to have activities in more than one market. This allows the firms to spread their risks. In case one market is in decline, it still has another source of profit.
- Creates new markets: merging with a firm in a different industry will open up the firm to a new customer base, helping it to market its core products to this new market.
- Transfer of ideas: there could be a transfer of ideas and resources between the two businesses even though they are in different industries. This transfer of ideas could help improve the quality and demand for the two products.
- Inexperience can lead to mismanagement: if the firms are in entirely different industries and have no experience in the other’s industry, cooperating and managing the two industries may be difficult and could turn disastrous.
- Lose focus: merging with and focusing on an entirely new industry could cause the firm to lose focus of its core product.
- Culture clash: as with all kinds of mergers, there could be a culture clash between the two firms’ employees on practices, standards and ‘how things are done’.
Scale of Production
As a firm’s scale of production increases its average costs decrease. Cost saving from a large-scale production is called economies of scale.
Internal economies of scale are decisions taken within the firm that can bring about economies (advantages). Some internal economies of scale are:
- Purchasing economies: large firms can be buy raw materials and components in bulk because of their large scale of production. Supplier will usually offer price discounts for bulk purchases, which will cut purchasing costs for the firm.
- Marketing economies: large firms can afford their own vehicles to distribute their products, which is much cheaper than hiring other firms to distribute them. Also, the costs of advertising is spread over a much large output in large firms when compared to small firms.
- Financial economies: banks are more willing to lend money to large firms since they are more financially secure (than small firms) to repay loans. They are also likely to get lower rates of interest. Large firms also have the ability to sell shares to raise capital (which do not have to be repaid). Thus, they get more capital at lower costs.
- Technical economies: large firms are more financially able to invest in good technology, skilled workers, machinery etc. which are very efficient and cut costs for the firm.
- Risk-bearing economies: large firms with a high output can sell into different markets (even overseas). They are able to produce a variety of products (diversification in production). This means that their risks are spread over a wider range of products or markets; even if a market or product is not successful, they have other products and markets to continue business in. Thus, costs are less.
External economies of scale occur when firms benefit from the entire industry being large. This may include:
- Access to skilled workers: large firms can recruit workers trained by other firms. For example: when a new training institution for pilots and airline staff opens, all airline firms can enjoy economies of scale of having access to skilled workers, who are more efficient and productive, and cuts costs.
- Ancillary firms: they are firms that supply and provide materials/services to larger firms. When ancillary firms such as a marketing firm locates close to a company, the company can cut costs by using their services more cheaply than other firms.
- Joint marketing benefits: when firms in the same industry locate close to each other, they may share an enhanced reputation and customer base.
- Shared infrastructure: development in the infrastructure of an industry or the economy can benefit large firms. Examples: more roads and bridges by the govt. can cut transport costs for firms, a new power station can provide cheaper electricity for firms.
Diseconomies of scale occur when a firms grows too large and average costs start to rise. Some common diseconomies are:
- Management diseconomies: large firms have a wide internal organisation with lots of managers and employees. This makes communication difficult and decision-making very slow. Gradually, it leads to inefficient running of the firms and increases costs.
- Too much output may require a large supply of raw materials, power etc. which can lead to shortage and halt production, increasing costs.
- Large firms may use automated production with lots of capital equipment. Workers operating these machines may feel bored in doing the repetitive tasks and thus become demotivated and less cooperative. Many workers may leave or go on strikes, stopping production and increasing costs.
- Agglomeration diseconomies: this occurs when firms merge/acquire too many different firms producing different products, and the managers and owners can’t coordinate and organise all activities, leading to higher costs.
- More shares sold into the market and bought means more owners coming into the business. Having a lot of owners can lead to a lot of disputes and conflicts among themselves.
- A lot of large firms can face diseconomies when their products become too standardised and less of a variety in the market. This will reduce sales and profits and increase average costs.
A firm that doubles all its inputs (resources) and is able to more than double its output as a result, experiences increasing returns to scale.
A firm that doubles all its inputs and fails to double its output as a result, experiences a decreasing or diminishing returns to scale.
Notes submitted by Lintha
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13 thoughts on “3.5 – Firms”
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