Welcome to the World of Firms and Production!

Hello Economist! This chapter is all about the decisions made by the engine room of the economy: Firms (or businesses). You will learn how companies are classified, why some succeed and grow, how they manage their costs, and ultimately, what their goals are.

Understanding firms is essential because they decide what gets produced, how much it costs, and who they employ. Mastering this section gives you great insight into the microeconomic choices that shape your everyday life!

3.5 Classification, Size, and Growth of Firms

3.5.1 How are Firms Classified?

Firms can be classified in two main ways: by the type of activity they perform (sector) and by who owns them (sector).

A. By Sector (Type of Activity)
  • Primary Sector: Extracts raw materials directly from the earth or sea.
    Example: Farming, fishing, mining, forestry.
  • Secondary Sector: Manufactures or processes raw materials into finished or semi-finished goods.
    Example: Car manufacturing, construction, clothing factories.
  • Tertiary Sector: Provides services rather than goods.
    Example: Banking, education, healthcare, transport, retailing.

Did you know? As a country develops economically, the tertiary sector usually becomes the largest employer!

B. By Ownership
  • Private Sector: Businesses owned, controlled, and run by private individuals (e.g., sole traders, private limited companies). Their main aim is usually profit maximisation.
  • Public Sector: Organisations owned and controlled by the government (e.g., state hospitals, national railways, police). Their main aim is usually social welfare (serving the public).

3.5.2 Small Firms: Why They Exist

Despite the giants like Apple or Toyota, small firms are everywhere. They are defined relative to their industry (e.g., number of employees, turnover, market share).

Why do Small Firms Exist?

  1. Niche Markets: They serve a small, specific market that large firms aren't interested in (e.g., a boutique tailor).
  2. Flexibility: They can adapt quickly to changing consumer tastes or technology.
  3. Personal Service: Customers prefer dealing with the owner directly (e.g., local bakery).
  4. Lack of Capital: The owner may not have enough money to start a large operation.
  5. Barriers to Entry: Some markets are simply too small for large firms to enter.

Challenges Facing Small Firms:

  • Difficulty raising finance (banks see them as riskier).
  • Lack of economies of scale (they pay more per unit for inputs).
  • Intense competition from larger rivals.
  • Owner must handle many roles (management, marketing, finance).

3.5.3 and 3.5.4 Causes and Forms of Growth (Mergers)

Firms grow for many reasons, often to increase market share, gain greater profits, or enjoy better economies of scale.

A. Internal (Organic) Growth

This means growing naturally by expanding existing operations.

  • Building a new factory.
  • Hiring more staff.
  • Developing new products.
  • Increasing market share through successful advertising.
B. External Growth (Mergers and Takeovers)

This involves joining with another existing firm.

  • A Merger is when two firms agree to join together, usually under a new name.
  • A Takeover (or acquisition) is when one firm buys enough shares to gain control of another firm (often against the target company's wishes).

There are three types of mergers, defined by the relationship between the two firms:

Type of Merger Definition Example
1. Horizontal Firms in the same industry and at the same stage of production join. Two car manufacturers merge.
2. Vertical Firms in the same industry but at different stages of production join.
  • Backward: Car maker buys a tyre factory.
  • Forward: Car maker buys a car dealership.
3. Conglomerate Firms in completely different industries join. A coffee company merges with a clothing brand.

Advantages of Mergers:

  • Increased Market Share: The combined firm captures a larger slice of the total market.
  • Economies of Scale: The new, larger firm can produce more cheaply (see next section).
  • Reduced Competition: Especially horizontal mergers, which removes a rival.

Disadvantages of Mergers:

  • Diseconomies of Scale: The firm becomes too big to manage efficiently.
  • Job Losses: Duplicated jobs (like two accounting departments) are cut.
  • High Costs: The merger process itself can be very expensive and complex.

Quick Review: Firms and Growth

The biggest advantage of growth is gaining Economies of Scale, which means lower costs per unit of output. Let’s dive deeper into this key concept.

3.5.5 Economies and Diseconomies of Scale (EoS and DeS)

Don't worry if this seems tricky! We are talking about average cost (the cost to produce one item) changing as the size of the business (scale of production) changes.

Key Definition:
Economies of Scale (EoS): The reduction in a firm’s average costs of production as the firm increases the size (scale) of its operations.

Think of EoS like buying in bulk at a warehouse store—the individual price drops the more you buy.

Internal Economies of Scale

These savings come from *within* the firm as it grows larger.

  1. Purchasing Economies: Buying inputs (raw materials, components) in large quantities usually means a cheaper price per unit (bulk buying discounts).
  2. Financial Economies: Large firms can often borrow money more easily and at lower interest rates than small firms, as banks view them as less risky.
  3. Technical Economies: Large firms can afford to use highly efficient, specialised machinery and mass production techniques. Small firms often have to use less efficient, general-purpose equipment.
  4. Managerial Economies: Large firms can afford to hire specialised managers (e.g., HR, Marketing, Finance experts), leading to better decisions and lower overall costs.
  5. Risk-bearing Economies: Large firms often produce a wide range of products or operate in different geographical markets. If one product fails, the others can cover the loss, spreading the risk.

Memory Trick: Remember the main Internal EoS using the acronym: Financial, Managerial, Technical, Purchasing, Risk-bearing (FMT PR).

External Economies of Scale

These savings occur when an entire industry (not just one firm) grows in a specific area.

  1. Specialised Suppliers: As an industry grows (e.g., technology companies), specialised support industries and suppliers may set up nearby, lowering costs for everyone.
  2. Skilled Labour Pool: If many similar firms are in one area (e.g., Silicon Valley), training schools or universities might start offering specialised courses, creating a ready supply of skilled workers.
  3. Improved Infrastructure: Local and national governments may build better transport links or communication networks to support the growing industry.

Key Definition:
Diseconomies of Scale (DeS): The increase in a firm’s average costs of production as the firm becomes too large and difficult to manage.

DeS happen when complexity and bureaucracy start dragging the firm down.

  1. Communication Problems: As the firm grows, information takes longer to pass through many layers of management, leading to slower, worse decision-making.
  2. Coordination and Control Problems: It becomes difficult for top managers to monitor and coordinate all the different departments, factories, and global operations.
  3. Loss of Motivation: Workers may feel disconnected from the top management in a huge organisation, leading to lower morale, lower efficiency, and higher absenteeism.

Key Takeaway for EoS/DeS: EoS drive average costs down; DeS drive average costs up. They explain why some firms grow massive while others stay small.

3.6 Firms and Production

3.6.1 Demand for Factors of Production (FoPs)

Firms need the four factors of production (Land, Labour, Capital, Enterprise) to create output. The demand for these factors is a derived demand—it depends on the demand for the final product they help create.

What influences how much of a factor a firm demands?

  • Demand for the Product: If demand for the final product (e.g., smartphones) increases, the firm will demand more factors (e.g., labour and capital) to make them.
  • Price of Factors: If the cost of capital (e.g., machinery rental) falls, the firm might substitute it for labour (if labour is now relatively more expensive).
  • Productivity of Factors: If a worker or machine becomes more productive, the firm will be willing to pay more for it or demand more of it, as it delivers more output per cost.
  • Availability of Factors: If skilled labour is scarce, a firm might be forced to switch to more capital-intensive methods.

3.6.2 Labour-Intensive vs. Capital-Intensive Production

Firms must choose the right mix of labour and capital (machinery/technology) to minimise costs and maximise efficiency.

  • Labour-Intensive: Production relies heavily on human workers.
    Advantage: High flexibility, often required for high-skill, bespoke goods (e.g., fine dining restaurants, tailor-made clothes).
    Disadvantage: Labour costs can be high, and output is limited by human speed.
  • Capital-Intensive: Production relies heavily on machinery and technology.
    Advantage: Consistent quality, high volume output (mass production), lower average costs due to EoS.
    Disadvantage: High initial investment cost, less flexible to change.

3.6.3 Production and Productivity

It is vital to distinguish between these two terms:

1. Production: The process of transforming inputs (FoPs) into outputs (goods and services). It is simply the total amount of output produced.
Example: A factory produces 1,000 cars per month.

2. Productivity: Measures the efficiency of production. It is the output per unit of input (usually per worker or per hour).
Example: If 10 workers produce 1,000 cars, labour productivity is 100 cars per worker.

Why is productivity important? Increasing productivity means a firm can produce more output with the same resources, which lowers average costs and increases profitability.

Influences on Productivity:

  • Quality of Labour: Education, training, and experience.
  • Quality of Capital: Using up-to-date technology and machinery.
  • Management: Efficiency of organisation and motivation of workers.

3.7 Firms' Costs, Revenue, and Objectives

3.7.1 & 3.7.2 Defining and Calculating Costs of Production

Costs are critical because they determine if a firm can make a profit.

A. Fixed Costs (FC)

Costs that do not change with the level of output (in the short run). They must be paid even if output is zero.
Examples: Rent, insurance premiums, loan interest, salaries for permanent managers.

B. Variable Costs (VC)

Costs that change directly with the level of output. If output is zero, variable costs are zero.
Examples: Raw materials, electricity used in production, wages paid per hour.

C. Total Costs (TC)

The sum of fixed costs and variable costs.

$$ TC = FC + VC $$

D. Average Costs (Cost per Unit)

These costs show the cost needed to produce *one* unit of output, \(Q\).

  • Average Fixed Cost (AFC): Fixed cost divided by output. AFC always falls as output rises.
    $$ AFC = \frac{FC}{Q} $$
  • Average Variable Cost (AVC): Variable cost divided by output.
    $$ AVC = \frac{VC}{Q} $$
  • Average Total Cost (ATC): Total cost divided by output. This is the most important measure of efficiency!
    $$ ATC = \frac{TC}{Q} \text{ or } ATC = AFC + AVC $$

Common Mistake to Avoid: When asked to calculate total cost, remember to include BOTH fixed and variable components!

3.7.3 & 3.7.4 Defining and Calculating Revenue

Revenue is the income a firm receives from selling its goods or services.

Total Revenue (TR): The total income generated from sales. It is calculated by multiplying the price of the good (\(P\)) by the quantity sold (\(Q\)).

$$ TR = P \times Q $$

Average Revenue (AR): The revenue received per unit sold. Since a firm usually sells all its units at the same price, the Average Revenue is equal to the Price (\(P\)).

$$ AR = \frac{TR}{Q} = P $$

3.7.5 Objectives of Firms

While we often assume firms want maximum profit, real-world firms have several objectives:

  1. Profit Maximisation (TR > TC): This is the classic economic assumption. A firm maximises profit when it produces at the output level where the gap between Total Revenue (TR) and Total Cost (TC) is largest.
  2. Growth: Increasing the size of the firm (in terms of market share, revenue, or assets). Growth is often pursued even if it doesn't maximise short-term profit, as a larger firm is more secure and can gain more EoS.
  3. Survival: Especially important for new firms or firms facing a recession (like during a global pandemic). The goal is simply to avoid making a loss and stay afloat.
  4. Social Welfare/Satisfaction: Public sector organisations or non-profit firms prioritise providing a necessary service or benefit to society over making a profit. Even private firms may pursue Corporate Social Responsibility (CSR), which involves sacrificing some profit for ethical or environmental goals.

Key Takeaway for Costs & Objectives: Profit is the difference between TR and TC. Firms often choose objectives like survival or growth over immediate profit maximisation, especially if the economy is struggling.

3.8 Market Structure

The structure of a market (how many firms there are, how much power they have) greatly affects how consumers are treated and how firms behave. We focus on two main structures: highly competitive markets and monopolies.

3.8.1 Competitive Markets

In a highly competitive market, there are a high number of firms selling similar or identical products.

Think of a local farmer's market or a street with many identical small restaurants.

Effects of High Competition:

  • Price: Prices tend to be low because firms constantly undercut each other to attract customers.
  • Quality: Quality must be high, or customers will switch easily to a rival.
  • Choice: Consumers have a wide variety of choices.
  • Profit: Profits tend to be low (only enough to cover costs and stay in business), as any surplus profit attracts new firms into the market.

3.8.2 Monopoly Markets

A monopoly exists when there is either one single firm dominating the market, or a firm that has significant control over the supply of a product.

Characteristics of a Monopoly
  • Single Seller/Dominant Firm: One company controls the vast majority of the market.
  • Unique Product: The product has no close substitutes.
  • High Barriers to Entry: It is extremely difficult for new firms to enter the market (e.g., due to huge start-up costs, or legal protection like patents).
Advantages of Monopolies (Why they might be good)
  1. Research and Development (R&D): Because monopolies earn high profits, they have large budgets to invest in R&D, leading to innovation and new products over time.
  2. Economies of Scale: Since they are the only (or the largest) producer, they can achieve massive EoS, potentially leading to lower average production costs.
Disadvantages of Monopolies (Why they are often bad for consumers)
  1. Higher Prices: Without competition, a monopolist can charge higher prices than in a competitive market, reducing consumer welfare.
  2. Less Choice: Consumers have only one source for the product.
  3. Inefficiency: Without the pressure of competition, a monopoly may become complacent, leading to slower innovation and high production costs (known as productive inefficiency).

Final Review: Microeconomic Decision Makers
Firms, as microeconomic decision makers, choose their scale, their production methods, and their objectives. These decisions are heavily influenced by the costs they face (FC, VC) and the structure of the market they operate in (competitive or monopoly).