Economics | Types and sizes of businesses

Welcome to Business Behaviour: Types and Sizes of Businesses!

Hello future economist! This chapter is all about understanding the different 'actors' in the economy – the businesses themselves. We need to know who owns them, how big they get, and, most importantly, what motivates their decisions. This foundational knowledge is crucial because a firm's legal structure and objectives directly influence its behaviour, output, pricing, and ultimately, its impact on the market.

Don't worry if some of the legal terms seem tricky. We will break down key concepts like liability and principal-agent conflict step-by-step!

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Section 1: Types of Business Ownership (The Legal Structure)

The legal structure of a business determines how risk and control are handled. The most important concept here is liability.

Key Concept: Liability Explained

Liability refers to the extent to which the owners are legally responsible for the debts of the business.

• Unlimited Liability: The owner is personally responsible for all business debts. If the business fails, creditors can seize the owner's personal assets (house, car, savings). This is a high-risk structure.
• Limited Liability: The personal assets of the owners are legally separate from the business debts. The maximum an owner can lose is the amount they invested in the business (e.g., the value of their shares). This acts like a protective bubble.

1. Sole Traders and Partnerships

Sole Trader

• Definition: A business owned and controlled by one person. (e.g., a freelance graphic designer or a small local plumber).
• Liability: Unlimited Liability.
• Pros: Easy to set up, owner keeps all profit, quick decision-making.
• Cons: High risk, difficulty raising capital, heavy workload.

Partnership

• Definition: A business owned by two or more people. (e.g., a small legal or accounting firm).
• Liability: Usually Unlimited Liability (though some modern structures allow Limited Liability Partnerships – LLPs).
• Pros: Shared workload and expertise, easier to raise capital than a sole trader.
• Cons: Profits are shared, potential for disagreement, partners are liable for each other's mistakes (joint and several liability).

2. Limited Companies

Companies are separate legal entities from their owners (shareholders). This is the key to limited liability.

Private Limited Company (Ltd)

• Definition: Companies whose shares are sold privately to friends, family, or existing investors. They cannot sell shares to the general public.
• Liability: Limited Liability.
• Pros: Limited liability protects the owners, easier to raise finance than partnerships.
• Cons: More complex paperwork, profits must be shared among more people.

Public Limited Company (PLC)

• Definition: Large companies whose shares are offered and traded publicly on a stock exchange. (e.g., Amazon, Shell, Toyota).
• Liability: Limited Liability.
• Pros: Can raise vast amounts of capital quickly through the stock market, enjoys massive economies of scale.
• Cons: Highly regulated, required to disclose detailed financial information publicly, separation of ownership and control (see Section 3).

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Section 2: Objectives of Firms (What Do They Want?)

While the textbook often assumes firms aim for maximum profit, real-world businesses pursue a variety of goals.

1. Profit Maximisation (The Traditional Goal)

Goal: To achieve the highest possible level of profit.

Economic Condition: A firm maximises profit where the additional revenue from selling one more unit (Marginal Revenue, MR) equals the additional cost of producing that unit (Marginal Cost, MC).

\[ MR = MC \]

Why: Profit provides funds for investment, pays dividends to shareholders, and acts as a reward for risk-taking.

Common Mistake to Avoid: Firms don't necessarily maximise profit by setting the highest possible price. They maximise profit by setting the output level where \(MR = MC\).

2. Revenue Maximisation

Goal: To achieve the highest possible total revenue (sales turnover).

Economic Condition: Revenue is maximised when Marginal Revenue (MR) is zero. Selling any further unit would start decreasing total revenue.

\[ MR = 0 \]

Why: Managers might pursue this objective because their salaries or bonuses are often linked to the size of the company's sales or market share, rather than pure profit.

3. Sales Maximisation (or Maximising Market Share)

Goal: To maximise the volume of sales or output, often subject to a constraint (like breaking even).

Economic Condition: Output is maximised when Average Cost (AC) equals Average Revenue (AR), meaning the firm is earning normal profit (zero economic profit).

\[ AC = AR \]

Why: This is often a strategic goal to drive out competitors, deter new entrants, or gain dominant market share, even if it means sacrificing supernormal profit in the short run. A company might launch a product at cost-price just to gain massive adoption.

4. Satisficing

Goal: To achieve a satisfactory or acceptable level of performance (e.g., 'enough' profit) rather than striving for the absolute maximum.

Why: Once a certain target profit level is met, managers might use remaining time/resources to pursue personal objectives, like working less hard, improving working conditions, or spending on prestige projects (the executive jet analogy). This links directly to the conflict discussed below.

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Section 3: The Principal-Agent Problem

Understanding the Conflict

The Principal-Agent Problem occurs primarily in large businesses (PLCs) where there is a separation of ownership and control.

• The Principal: The owner (the shareholders). Their main objective is usually Profit Maximisation.
• The Agent: The manager or director hired to run the company. Their objectives might include Sales Maximisation, Satisficing, or personal benefits (salary, power, leisure).

The Problem: The Agent (manager) may pursue their own self-interest, which deviates from the objectives of the Principal (owner). Since shareholders cannot constantly monitor the management, managers have the flexibility to satisfy rather than maximise.

Did you know? This conflict often explains why large public companies, despite their potential, sometimes appear less efficient than smaller, owner-managed firms.

How to Resolve the Conflict

Owners try to align the agents' goals with their own:

1. Offering share options or bonuses tied directly to firm profitability or share price growth.
2. Threat of takeover: If the firm performs poorly (low profit), its share price drops, making it vulnerable to a takeover. This threat encourages existing management to work harder.
3. Increased monitoring by the board of directors.

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Section 4: Business Growth and Size

Firms can grow in two fundamental ways: internally (slow) or externally (fast).

1. Internal (Organic) Growth

Definition: Expansion funded by existing profits, retained earnings, or borrowing. The firm physically increases its own output capacity or opens new branches.

Example: A successful chain of coffee shops uses its profits to open one new outlet every year.

Pros: Lower risk, maintains existing company culture, management retains control.

Cons: Slow growth, capacity limited by internal resources.

2. External (Inorganic) Growth: Mergers and Takeovers

Definition: Growth achieved by combining with or buying another company.

• Merger: Two or more firms agree to join together to form one new company.
• Takeover (Acquisition): One firm buys enough shares in another firm to gain controlling interest.

Pros: Immediate increase in market share, rapid access to new markets or technologies.

Cons: High risk, expensive, potential for culture clashes, often leads to job losses.

Types of Integration (Based on relationship between merging firms)

i. Horizontal Integration

What: Firms at the same stage of production and in the same industry merge.

Example: Two rival mobile phone networks merging (Vodafone and O2).

Goal: Maximise economies of scale, eliminate competition, gain greater market power.

ii. Vertical Integration

What: Firms at different stages of production in the same industry merge.

• Backward Vertical Integration: Merging with a firm earlier in the supply chain (e.g., A car manufacturer buys a tyre factory). Goal: Control supply costs and quality.
• Forward Vertical Integration: Merging with a firm later in the supply chain (e.g., A book publisher buys a chain of bookstores). Goal: Control distribution and retail prices.

iii. Conglomerate Integration

What: Firms in completely unrelated industries merge.

Example: A food production company buys an insurance firm.

Goal: Diversify risk (if one market fails, the other might succeed). This is often less common as it is difficult to manage diverse operations.

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Section 5: Reasons for the Existence of Small and Large Firms

Even in modern economies, a huge number of small firms survive and thrive alongside giants. Why don't all firms grow large?

1. Why Small Firms Continue to Exist

• Niche Markets: Small firms can specialize in unique or highly specific markets (e.g., handmade bespoke furniture) where mass production is impossible or undesirable.
• Flexibility and Personal Service: They can adapt quickly to changing consumer tastes and offer highly personalised services that large firms cannot match.
• Lack of Economies of Scale: In some industries (like hairdressing or small construction), large scale offers no cost advantage.
• Barriers to Entry are Low: If it's easy to start a business, the market will always see new, small entrants.
• Owner Preference: Some entrepreneurs prefer to remain small to maintain control, avoid the stress of large-scale management, or avoid the complications of becoming a PLC.

2. Why Large Firms Dominate

• Economies of Scale (EOS): This is the biggest reason. Large firms can produce at a much lower average cost (AC) than small firms. (Think technical, marketing, or financial EOS).
• Market Power: Large size grants monopoly or oligopoly power, allowing them to influence prices, block entry, and achieve high profit margins.
• High Start-up/R&D Costs: Industries requiring massive initial investment (e.g., aerospace, pharmaceuticals) naturally favour large firms that can afford the research and development.
• Risk Bearing: Large firms can diversify their products/markets (conglomerate strategy) to spread risk.