Economics (0455) | Firms

Study Notes: Microeconomic Decision Makers - Firms

Hello future economists! This chapter is all about the **firm** (also called a producer or business). Firms are the engine of production in the economy, and understanding how they operate—from their size and costs to their goals and market environments—is crucial for IGCSE Economics. Let's dive into the world of businesses!

---

Section 1: Classification, Size, and Growth of Firms (Syllabus 3.5)

1.1 Classifying Firms

Firms are often grouped based on what they produce (sector) and who owns them (ownership).

1. By Sector (What they do):

• Primary Sector: Firms that extract or harvest natural resources.
  Examples: Farming, fishing, mining, oil extraction.
• Secondary Sector: Firms that manufacture or construct finished goods.
  Examples: Car manufacturing, construction companies, clothing factories.
• Tertiary Sector: Firms that provide services. This is often the largest sector in developed countries.
  Examples: Banks, schools, hospitals, retailers, transport services.

2. By Ownership (Who runs them):

• Private Sector: Businesses owned and run by private individuals. Their main aim is usually **profit maximisation**.
• Public Sector: Organisations owned and controlled by the government or state. Their main aim is usually **social welfare** (providing essential services).
  Examples: Public schools, state hospitals, national defence.

1.2 The Role and Challenges of Small Firms

Most businesses start small! Even though large multinational companies dominate the headlines, small firms are vital for the economy.

Reasons for the Existence of Small Firms:

1. Niche Markets: They serve highly specific, small markets that large firms wouldn't find profitable. (e.g., a specialist antique restorer).
2. Personal Services: They offer customised services that require personal attention. (e.g., a local hairdresser or independent tailor).
3. Low Start-up Costs: Certain industries (like online consultancy or gardening) require very little capital to begin.
4. Flexibility: They can quickly adapt to changing customer tastes or local market conditions.

Challenges Facing Small Firms:

• Difficulty raising finance (banks see them as high risk).
• Lack of **economies of scale** (buying in small quantities means higher costs).
• Intense competition from larger, established firms.
• The owner must often be skilled in all areas (management, finance, marketing).

1.3 Growth of Firms (3.5.3 and 3.5.4)

Firms want to grow to increase their profits, market share, influence, and security. Growth can happen in two main ways:

1. Internal (Organic) Growth:

The firm grows using its own resources, reinvesting profits, and selling more products.
Example: A local coffee shop opens a second branch using profits earned from the first store.

2. External Growth (Mergers and Takeovers):

This involves joining with or buying other existing firms.

A merger occurs when two or more companies agree to join together to form one larger company. A takeover (or acquisition) is when one company buys more than 50% of the shares in another company, gaining control.

Types of Mergers (Important Definitions!):

• Horizontal Merger: Firms at the same stage of production and in the same industry merge.
  Example: Two rival supermarket chains merge.
  **Advantage:** Maximises economies of scale and reduces competition.
• Vertical Merger: Firms at different stages of production in the same industry merge.
  • Backward Vertical Merger: Merging with a supplier. (e.g., A car manufacturer buys a tyre factory).
  • Forward Vertical Merger: Merging with a distributor/retailer. (e.g., A chocolate factory buys a chain of retail sweet shops).
  **Advantage:** Guarantees supply/distribution and better quality control.
• Conglomerate Merger: Firms in **unrelated** industries merge.
  Example: A technology company buys a farming business.
  **Advantage:** Spreads risk across different markets (if one industry fails, the other might still succeed).

---

Section 2: Economies and Diseconomies of Scale (Syllabus 3.5.5)

Don't worry if this sounds complicated! It just means: how does the size of a firm affect its average production cost?

2.1 Economies of Scale (EoS)

A Lower average cost of production as the scale of output Increases. Basically, the bigger you get, the cheaper it is to produce each unit.

Analogy: Buying 1 kg of flour is expensive per gram. Buying a whole tonne of flour is much cheaper per gram. Large firms benefit from buying in bulk.

Internal Economies of Scale: These benefits arise from the firm's own growth.

To remember the main types, think of the mnemonic: T F M M P R

1. Technical EoS: Large firms can afford expensive, highly efficient machinery (mass production).
2. Financial EoS: Large firms can borrow money more easily and at lower interest rates than small firms, as banks view them as less risky.
3. Managerial EoS: Large firms can afford to hire specialised managers (e.g., a Chief Marketing Officer or Head of HR), leading to greater efficiency in each department.
4. Marketing EoS: Large firms can spread the cost of advertising (like a national TV campaign) over millions of products.
5. Purchasing EoS: Buying raw materials or components in bulk leads to huge discounts (Bulk Buying EoS).
6. Risk-bearing EoS: Large firms can diversify their product range or sell in different geographical markets, spreading the risk if one product or market fails.

2.2 Diseconomies of Scale (DoS)

A Higher average cost of production as the scale of output Increases.

If a firm gets too big, running it becomes inefficient.

1. Poor Co-ordination: The business becomes too complex, and different departments may not work together efficiently.
2. Poor Communication: Messages take longer to travel through the hierarchy, slowing down decision-making. Managers lose touch with the workers and customers.
3. Lack of Control: It's difficult for senior management to monitor thousands of employees and dozens of factories scattered globally. Waste and inefficiency can occur unnoticed.

2.3 External Economies and Diseconomies of Scale

These affect an **entire industry** or group of firms, not just one company, and arise from the industry or geographical area growing.

• External Economies of Scale (Benefit): When the industry grows, all firms benefit. Example: If many IT firms locate in one area (like Silicon Valley), specialised training institutions, infrastructure, and skilled workers will develop, benefiting every firm there.
• External Diseconomies of Scale (Drawback): When the industry grows too large, all firms suffer. Example: Too many factories in one area lead to increased traffic congestion (slowing down deliveries) and higher local labour costs due to increased competition for workers.

---

Section 3: Firms and Production (Syllabus 3.6)

3.1 Demand for Factors of Production

A firm needs Land, Labour, Capital, and Enterprise (Factors of Production). The demand for these factors is a **derived demand**—it only exists because there is a demand for the final product they help create.

What influences a firm's demand for factors?

1. Demand for the Product: If consumers suddenly want more *iPhones*, the demand for the labour and capital used to make *iPhones* increases.
2. Price of Factors: If the price of capital (machinery) falls relative to the price of labour (wages), the firm may choose to substitute labour for capital.
3. Factor Availability: If highly skilled labour is hard to find, the firm might switch to using more capital.
4. Factor Productivity: A factor that is highly productive (e.g., efficient capital or well-trained labour) is in higher demand because it reduces average costs.

3.2 Production Methods (Intensive Production)

Firms must decide the mix of labour and capital they use.

• Labour-intensive production: Uses a high proportion of labour relative to capital. Common where labour is cheap and products are customised.
  Advantages: Flexibility, easier adaptation to custom orders.
  Disadvantages: Wages can rise, slower, potential for human error.
• Capital-intensive production: Uses a high proportion of capital (machinery/technology) relative to labour. Common where labour is expensive, or large-scale, consistent production is needed.
  Advantages: Consistency, high productivity, lower long-term average costs, works 24/7.
  Disadvantages: High initial investment, less flexible, potential for job losses (unemployment).

3.3 Production vs. Productivity

These two terms sound similar but are very different!

• Production: Simply the **total output** of goods and services produced by a firm or economy. (The total number of cars made).
• Productivity: Measures the **efficiency** of production. It is the output per unit of input (usually per worker or per hour). (The number of cars made *per worker*).

\(Productivity = \frac{Total\,Output}{Total\,Input\,Used}\)

Influences on Productivity:

1. Education and Training (Labour Quality): Better-skilled workers are more productive.
2. Technology and Capital: Using modern, fast machinery increases output per worker.
3. Motivation and Wages: Workers who are well-paid or motivated often work harder.
4. Specialisation (Division of Labour): Breaking the production process into small, repetitive tasks increases efficiency.

---

Section 4: Firms' Costs, Revenue, and Objectives (Syllabus 3.7)

4.1 Understanding Costs of Production

Costs are the money spent by the firm on factors of production. We separate costs into two groups:

1. Fixed Costs (FC):

Costs that **do not change** with the level of output. You pay them even if you produce nothing.
Examples: Rent, insurance premiums, interest on loans, salaries for permanent management staff.

2. Variable Costs (VC):

Costs that **change** directly with the level of output. If output rises, VC rises. If output is zero, VC is zero.
Examples: Raw materials, electricity used for running machinery, wages paid per hour to factory workers.

Total Cost (TC) is the sum of these two:

\[TC = FC + VC\]

4.2 Calculation of Costs (The Averages)

When firms make decisions, they look at **Average Costs** because this tells them how much each unit produced costs them.

Average Cost is always calculated by dividing the Total Cost measure by the quantity (Q) produced.

Average Fixed Cost (AFC): Fixed cost per unit of output.

\[AFC = \frac{FC}{Q}\]
Note: AFC continuously falls as output increases, because the fixed cost is being spread over more units.

Average Variable Cost (AVC): Variable cost per unit of output.

\[AVC = \frac{VC}{Q}\]

Average Total Cost (ATC) or Average Cost (AC): Total cost per unit of output.

\[ATC = \frac{TC}{Q}\]

Also: \(ATC = AFC + AVC\)

4.3 Definition and Calculation of Revenue

Revenue is the money earned by the firm from selling its goods or services.

Total Revenue (TR): The total money received from sales.

\[TR = Price \times Quantity\,Sold\]

Average Revenue (AR): The revenue received per unit sold. Since a firm typically charges one price (P) per unit, the Average Revenue is usually the same as the Price.

\[AR = \frac{TR}{Quantity\,Sold} = Price\]

The total revenue of a firm is heavily influenced by how much it sells, which itself is affected by the price it sets and the demand elasticity of the product (a concept you studied earlier).

4.4 Objectives of Firms

Why do firms exist? The traditional answer is profit, but especially in larger, modern companies, objectives can be varied.

1. Profit Maximisation: The classic economic objective. This means achieving the largest possible difference between Total Revenue and Total Cost (\(TR - TC\)). This is often the goal of small, private sector firms.
2. Survival: Especially important for new firms or during economic recessions. The focus is simply to keep the business operating, even if profits are low or zero.
3. Growth: Increasing the size (e.g., market share, number of employees, total output). Managers often focus on growth because it provides them with higher status, security, and salaries.
4. Social Welfare/Satisfaction: Public sector firms often aim to provide essential services, even if they run at a loss. Private firms may also pursue *Corporate Social Responsibility* (CSR) goals, focusing on ethical production or environmental friendliness.

---

Section 5: Market Structure (Syllabus 3.8)

The market structure describes the competitive environment in which a firm operates. We focus on two main extremes: competitive markets (many firms) and monopoly markets (one dominant firm).

5.1 Competitive Markets (High Number of Firms)

When there are a high number of firms competing, the market tends to be highly competitive.

Effect of High Competition:

• Price: Prices tend to be lower. Firms cannot raise prices easily because consumers will simply buy from a competitor.
• Quality: Quality must be high, and innovation is encouraged, as firms try to differentiate themselves to gain market share.
• Choice: Consumers benefit from a wide variety of goods and services (high choice).
• Profit: Profits tend to be lower (just enough to keep the firm running), as intense competition drives down prices and raises costs (like advertising).

5.2 Monopoly Markets

A monopoly exists when a single firm dominates the market (usually defined as having 25% or more of market share, or being the *only* provider).

Characteristics of a Monopoly:

• **Single Seller:** Often only one major firm provides the good or service.
• **High Barriers to Entry:** It is extremely difficult for new firms to enter the market (e.g., due to huge start-up costs, legal protection, or exclusive control over resources).
• **Price Maker:** The monopoly has significant control over the price because there are no close substitutes.

Advantages of Monopoly:

1. Economies of Scale: Since the monopoly is often very large, it benefits from huge economies of scale, potentially leading to lower costs.
2. Research and Development (R&D): High monopoly profits can be reinvested into R&D, leading to innovation and technological improvements (which benefits society in the long run).

Disadvantages of Monopoly:

1. Higher Prices: Monopolies can charge higher prices because consumers have little choice.
2. Lower Quality/Choice: Since the firm faces little competition, there is less incentive to improve quality or offer a wide range of products.
3. Inefficiency: Without competitive pressure, the monopoly may become inefficient (known as *X-inefficiency*).