Firms-Economics chapter 20

• Classification of firms: Economic sector:

  Firms can be classified according to the economic sector in which they operate:

  • Primary sector- This sector of the economy contains firms that extract raw materials from the earth. Fishing, mining, agricultural farming
  • Secondary sector- This sector contains firms that : manufacture goods, changing raw materials into finished products, and construct buildings, roads and bridges
  • Tertiary sector: This sector contains firms that provide services to the general public and other firms. Retail shops, doctors, dentists
• Private sector firms are owned by private individuals and owners. Their main aim is to earn profit. The private sector refers to economic activity of private individuals and firms. The private sector's main aim is to earn profit for its owners
• Private sector firms:

  • Sole trader: A business owned and controlled by a single person
  • Partnership: A business owned by 2-20 people, with share ownership and risk taking
  • Private limited company: A business owned by shareholders, who are unable to buy or sell shares without the consent of other shareholders (can buy and sell shares to family and friends)
  • Public limited company: A business owned by shareholders, who can openly and freely buy or sell their shares on the stock exchange (buy and sell shares to public)
• Public sector firms are owned by the government. Their main aim is to provide a service to the general public (like education or healthcare services). Public sector refers to economic activity directly involving the government, such as the provision of state education and healthcare services. The public sector's main aim is to provide a service.
• The relative size of firms:

  A third way to classify firms is according to their relative size

  • Number of employees :The more employees, the larger the firm is. But some firms are capital intensive and hire few workers.
  • Market share: This measures a firm's sales revenues as a proportion of the industry's sales revenue. Larger firms may dominate sales in the market they supply. However, not all markets are large, like firms serving niche markets will be small.
• The relative size of firms:

  • Market capitalisation of a firm: This is the stock market value of a company, calculated by multiplying the total number of shares in the business by the current share price.
  • Sales revenue of a firm: This is measured by multiplying the unit price of a product by the quantity sold. Higher sales revenue means the company is larger. Can't use this method to compare across different industries.
• Small firms:

  There are several reasons why small firms co-exist with larger firms in the economy:

  • A small grocery store has to find a way to compete with supermarkets and it might do so by providing a range of goods which cannot be bought in a supermarket, like specialty wines.
  • The small store may be located in a remote area and be the only local seller of provisions
  • It may provide a personal shopping experience for customers, as compared to a self-service style experience at large supermarkets
  • Smaller shops can also adapt quickly to changing consumer tastes.
• • A sole trader (or sole proprietor) is an individual who owns his or her personal business.
  • The owner runs and controls the business and is the sole person held responsible for its success or failure.
  • This is the most common type of business ownership. Examples are self-emplooyed painters and decorators, plumbers, mechanics, freelance photographers.
  • Sole proprietorships are often small family run businesses and can be set up with relatively little capital, usually obtained from personal savings and borrowing.
• Advantages of small firms:

  • Few legal formalities exist. This means that sole proprietorships are quite easy to set up. Start-up costs are also usually much lower than in setting up larger types of business.
  • The sole trader is the only owner of a firm and therefore receives all of the profits made by the business. This gives them an incentive to work hard to become successful
  • Being your own boss can have some advantages: not having to take orders from others, having flexibility in decisions making (like dictating your working hours), and enjoying higher self-esteem from being successful
• Advantages of small firms:

  • Small businesses are likely to know their customers on a more personal level and this can lead to better relationships. Larger firms might not have the time to get to know their customers, so their services often become impersonal
  • Small firms are easier to manage and control. Larger firms can suffer from diseconomies of scale due to coordination problems
• Disadvantages and challenges facing small firms:

  • Small firms have limited start-up capital, making it difficult to raise finance to establish the business. Sole traders may find it difficult to secure funds beyond their savings. Trying to expand the business can also be problematic due to the lack of sources of finance available to the small business.
  • Statistically, small firms have the largest risk of business failure. The vast number of small firms creates intense competition, even for successful businesses. Larger, more established firms threaten the small firms' survival.
• Disadvantages and challenges facing small firms:

  • The success of small firms very much depends on the abilities and commitment of the owners. Sole traders often have to do their own financial accounts, marketing and management of human resources. They are unlikely to be equally effective in the different roles, and having to do all these tasks adds to the workload, stress and challenges in running a small firm
• Disadvantages/challenges facing small firms:

  • Small firms often suffer from a lack of continuity. The running of the business can be jeopardised if the owner is not there, maybe due to going on holiday, or due to illness. This creates problems of continuity for small firms.
  • As they are unable to exploit the benefits of large-scale production, small firms have higher unit costs of production. Subsequently, their prices tend to be less competitive than those of larger competitors (which benefits from economies of scale). This can reduce the competitiveness and profits of smaller firms.
• Internal growth:

  • Internal growth or organic growth occurs when firms expand using their own resources.
  • Firms can grow by increasing the number of branches (stores) within a particular country or by opening branches in different countries.
  • They can also expand by selling their products in a greater number of countries and can finance this expansion using profits earned within the business. These strategies help the firm ot increase its market share.
• External growth:

  • Occurs when expansion involves another organisation, such as through mergers, takeovers and franchises.
• External growth: Mergers:

  • In a merger, two firms agree to form one new company
  • For example, the MTRC and KCRC railway companies in Hong Kong merged in 2007 to become one company which is now the only provider of railway and underground railways services in Hong Kong.
  • They formed a monopoly, but any fare increases must be approved by the government.
• External growth: Takeovers:

  • By buying a majority stake (share) in another business, a firm can take over the target firm and instantly increase its size.
  • They may do this to gain larger share of the global market.
  • Tkaovers can be hostile, which means that the firm being taken over does not agree to the buyout. However, they can also be agreeable to both firms
• External growth: Franchising:

  • In a franchise, an individual or a firm purchases a license from another firm to trade using the name of the parent company.
  • Can help to expand a company
• A franchise involves a person or business buying a license to trade using another firm's name, logos, brands and trademarks.
• Horizontal merger benefits:

  • The merged firms can have higher market share
  • Can gain skilled employees from each other
  • They can operate with fewer employees (as the other business may already have a finance department, so you don't need your own finance department), so this may reduce costs of production
  • The business can take advantage of economies of scale
• Horizontal merger drawbacks:

  • There may be a duplication of resources, so some workers may lose their jobs. Job losses cause anxiety and demotivate staff and lead to a fall in productivity.
  • The newly formed, larger firm may face increasing costs arising from diseconomies of scale
  • The new firm may suffer from culture clashes between the merged businesses. Initially, this may cause communication and organisational problems for the firm
• Vertical mergers:

  • A vertical merger occurs when integration takes place between two firms from different economic sectors of industry/ stages of production
  • Two types of vertical merger: Backward and forwardd
• Backward vertical merger:

  • Occurs when a firm from the secondary sector merges with a firm from the primary sector, or when a firm from the tertiary industry merges with a firm operating in the secondary or primary sector
  • Benefits:
  • The firm in the secondary sector has control over the quality of raw materials with which it is supplied
  • The price of raw materials fall as the manufacturer does not have to pay another (external) firm for the raw materials
  • Drawbacks:
  • Transport costs increase for the merged firm as raw materials were previously delivered by external suppliers
• Forward vertical mergers:

  • Occurs when a firm from the primary sector of industry merges with a firm in the secondary or tertiary sector, or when a firm from the secondary sector merges with a firm operating in the tertiary sector
• Conglomerate mergers:

  • Occurs when two or more firms from different economic sectors and in unrelated areas of a business integrate to create a new firm
  • They can take advantage of risk-bearing economies of scale as diversification spreads risk
  • Diversification spreads risks by having various businesses in different industries, protecting failing ones.
  • Too much diversity in conglomerate can lead to capital and human resource management issues. Under-performing segments can drain resources from other areas of the conglomerate business.
• Economies of scale

  • Economies of scale are the cost-saving benefits of large-scale operations, which reduce average costs of production
  • Large firms are able to take advantage of economies of scale, which reduce their average costs of production. This gives them a cost advantage over small firms.
  • Economy means reduced expenditure/ saving, and scale refers to size. Therefore economies of scale means that the average costs of production fall as a firm grows or increases its output.
• Internal economies of scale

  • Internal economies of scale are the economies of scale that arise from the internal organisation of the business
  • Purchasing (bulk-buying): Occur when the cost of raw materials, components or finished goods falls when they are bought in large quantities
  • Technical economies of scale: Occur when large firms purchase expensive pieces of machinery and automated equipment for the production process. (better machinery can help reduce waste, and therefore costs)
• Internal economies of scale: Peppery Tycoons Fought Myopic Raptors Round Daffodils Menacingly

  • Financial economies of scale: Occur as large firms are able to borrow money from banks more easily than small firms because they are perceived by financial institutions to be less risky. A large firm will also have a greater value of assets, which can act as security for loans and mortgages.
• Internal economies of scale: Peppery Tycoons Fought Myopic Raptors Round Daffodils Menacingly

  • Managerial economies of scale: Occur if large firms have the resources to employ specialist managers to undertake functions in the firm. Despite the high salaries paid by large firms to attract specialists, overall productivity of the firm might increase, cutting unit costs.
  • Risk-bearing economies of scale: Occur as very large firms produce a range of products and operate in many locations. This diversity spreads risks as weak sales in one country can be supported by strong sales in another.
• Internal economies of scale: Peppery Tycoons Fought Myopic Raptors Round Daffodils Menancingly

  • Research and development economies of scale: Occur if large firms are able to fund Research and development and therefore can be innovative and create products that enable them to be market leaders
  • Marketing economies of scale: Occur as large firms tend to have large advertising budgets, so can spend large amounts of money on promoting their products
• External economies of scale:

  • External economies of scale are economies of scale that arise from factors outside of the firm
  • Proximity to related firms, availability of skilled labour, reputation of the geographical area, access to transportation networks
• External economies of scale: PARA

  • Proximity to related firms: If suppliers are located nearby the firm, it gives it easy access to the suppliers, therefore reducing transportation costs
  • Availability of skilled labour: If there's a pool of skilled workers, recruitment of workers with the necessary skills is relatively easy, thereby cutting costs for firms in the industry
• External economies of scale: PARA

  • Reputation of the geographical area: This provides all firms in the industry with free publicity and exposure. A large number of suitably qualified and skilled workers will flock to the area
  • Access to transportation networks: Manufacturing firms benefit from being located near major road networks, ports, so it's easier for them to deliver their manufactured products to consumers. A cafe/restaurant will benefit from being close to other shops, public transport links, parking facilities, will make the cafe more convenient to visit, more people will go.
• Diseconomies of scale:

  • Diseconomies of scale occur when average costs of production start to increase as the size of a firm increases.
  • Arises when a firm gets too large, so its average costs of production start to rise as output increases.
  • Poorer communication, slower decision making, lack of motivation
• Reasons for diseconomies of scale:

  • Communication issues may arise when a firm becomes too large. There may be too many branches to control and communicate with effectively, so decision-making may be slow due to the number of people in the communication chain. This may lead to increased costs of production.
  • A merger between two firms may be unsuccessful due to a clash of organisation cultures, so it may be beneficial to demerge
• Reasons for diseconomies of scale:

  • It may be necessary to employ more employees for all the firm's branches or a new factory may be needed to accommodate the increased production level. This will add to the total costs of production and average costs of production may rise
  • Workers within a large organisation may find it difficult to feel part of a large firm, leading to a lack of motivation and reduced productivity. Average costs will tend to rise.
  • Business may become too diverse and operate in areas which it has less expertise. Reduced control and coordination causes costs to increase.