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).

Small Firms
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.
External Growth
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.
Advantages:


 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.

Disadvantages:


 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.
Advantages:


 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.
Disadvantages:


 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.
Advantages:


 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.
Disadvantages:

 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.

Demand for Factors of Production

Some factors that determine the demand of factors of production:

 The demand for the product: if more goods and services are demanded by consumers, more
factors of production will be demanded by firms to produce and satisfy the demand. That is,
the demand for factors of production is derived demand, as it is determined by the demand for
the goods and services (just like labour demand).
 The availability of factors: firms will also demand factors that are easily available and
accessible to them. If the firm is located in a region where there is a large pool of skilled
labour, it will demand more labour as opposed to capital.
 The price of factors: If labour is more expensive than capital, firms will demand more
capital (and vice versa), as they want to reduce costs and maximize profits.
 The productivity of factors: If labour is more productive than capital, then more labour is
demanded, and vice versa.
Labour-intensive and Capital-intensive production
Labour-intensive production is where more labourers are employed than other factors, say
capital. Production is mainly dependent on labour. It is usually adopted in small-scale
industries, especially those that produce personalised, handmade products. Examples: hotels
and restaurants.
Advantages:

 Flexibility: labour, unlike most machinery can be used flexibly to meet changing levels of
consumer demand, e.g., part-time workers.
 Personal services: labour can provide a personal touch to customer needs and wants.
 Personalised services: labourers can provide custom products for different customers.
Machinery is not flexible enough to provide tailored products for individual customers.
 Gives feedback: labour can give feedback that provides ideas for continuous improvements
in the firm.
 Essential: labour is essential in case of machine breakdowns. After all, machines are only as
good as the labour that builds, maintains and operates them..
Disadvantages:

 Relatively expensive: in the long-term, when compared to machinery, labour has higher per
unit costs due to lower levels of productivity.
  Inefficient and inconsistent: compared to machinery, labour is relatively less efficient and
tends to be inconsistent with their productivity, with various personal, psychological and
physical matters influencing their quantity and quality of work.
 Labour relation problems: firms will have to put up with labour demands and grievances.
They could stage an overtime ban or strike if their demands are not met.
Capital refers to the machinery, equipment, tools, buildings and vehicles used in production.
It also means the investment required to do production. Capital-intensive production is
where more capital is employed than other factors. It is a production which requires a
relatively high level of capital investment compared to the labour cost. Most capital-intensive
production is automated (example: car-manufacturing).
Advantages:

 Less likely to make errors: Machines, since they’re mechanically or digitally programmed
to do tasks, won’t make the mistakes that labourers will.
 More efficient: machinery doesn’t need breaks or holidays, has no demands and makes no
mistakes.
 Consistent: since they won’t have human problems and are programmed to repeat tasks, they
are very consistent in the output produced.
 Technical economies of scale: increased efficiency can reduce average costs
Disadvantages:

 Expensive: the initial costs of investment is high, as well as possible training costs.
 Lack of flexibility: machines need not be as flexible as labourers are to meet changes in
demand.
 Machinery lacks initiative: machines don’t have the intuitive or creative power that human
labour can provide the business, and improve production.

Production and Productivity

A firm combines scarce resources of land, labour and capital (inputs) to make (produce)
goods and services (output). Production is thus, the transformation of raw materials
(input) to finished or semi-finished goods and services (output).
In other words, production is the adding of value to inputs to create outputs. It is the
production that gives the inputs value.
Some factors that influence production:

 Demand for product: the more the demand from consumers, the more the production.
 Price and availability of factors of production: if factors of production are cheap and
readily available, there will be more production.
 Capital: the more capital that is available to producers, the more the investment in
production.
 Profitability: the more profitable producing and selling a product is, the more the production
of the product will be.
 Government support: if governments give money in grants, subsidies, tax breaks and so on,
more production will take place in the economy.
Productivity measures the amount of output that can be produced from a given amount
of input over a period of time.
Productivity = Total output produced per period / Total input used per period
Productivity increases when:

 more output or revenue is produced from the same amount of resources

 the same output or revenue is produced using fewer resources.
(Labour productivity is the measure of the amount of output that can be produced by each
worker in a business).

Factors that influence productivity:

 Division of labour: division of labour is when tasks are divided among labourers. Each
labourer specializes in a particular task, and thus this will increase productivity.
 Skills and experience of labour force: a skilled and experienced workforce will be more
productive.
 Workers’ motivation: the more motivated the workforce is, the more productive they will
be. Better pay, working conditions, reasonable working hours etc. can improve productivity.
 Technology: more technology introduced into the production process will
increase productivity.
 Quality of factors of production: replacing old machinery with new ones, preferably with
latest technologies, can increase efficiency and productivity. In the case of labour, training the
workforce will increase productivity.
 Investment: introducing new production processes which will reduce wastage, increase
speed, improve quality and raise output will raise productivity. This is known as lean
production.
Costs of Production
Fixed costs (FC) are costs that are fixed in the short-term running of a business and have to
be paid even when no production is taking place. Examples: rent, interest on bank loans,
telephone bills. These costs do not depend on the amount of output produced.
Average Fixed Cost (AFC) = Total Fixed Cost (TFC) / Total Output

Variable costs (VC) are costs that are variable in the short-term running of a business and
are paid according to the output produced. The more the production, the more the variable
costs are. Examples: wages, electricity bill, cost of raw materials.
Average Variable Cost (AVC) = Total Variable Costs (TVC) / Total Output

Total Costs (TC) = Total Fixed Costs (TFC) + Total Variable Costs (TVC)

This is a simple graph showing the relation between TC,

FC and VC. The gap between the TC and TVC indicates the TFC

Average cost or Average total Cost (ATC) is the cost per unit of output.
Average Total Cost (ATC) = Total Cost (TC) / Total Output or
Average Cost (AC) = Average Variable Cost (AVC) + Average Fixed Cost (AFC)

(Remember ‘average’ means ‘per unit’ and so will involve dividing the particular cost by the
total output produced. In the graphs above you will notice that the average variable costs and
average total costs first fall and then start rising. This is because of economies of scale and
diseconomies of scale respectively. As the firm increases its output, the average costs decline
but as it starts growing beyond a limit, the average costs rise).
Let’s calculate some costs in an example:

Suppose, a TV manufacturer produces 1000 TVs a month. The firm’s fixed costs in rent is
$900, and variable cost per unit is $500. What would its TFC, TVC, AVC, AFC, AC and TC
be, in a month?

No. of units of TVs produced = 1000

Total Fixed Costs for one month = $900

Average Fixed Cost = $900 / 1000 = $0.9 per unit

Variable Cost of producing one unit of TV = $500

Total Variable Costs for producing 1000 TVs in a month = $500 * 1000 = $500,000
Average Variable Cost = $500,000 / 1000 = $500 (AVC is the same as VC per unit!)

Total Costs = Total Fixed Costs + Total Variable Costs ==> $900 + $500,000 = $500,900
Average Costs = Total Costs / Total Output ==> $500,900 / 1000 = $500.9
or Average Costs = AFC + AVC ==> $0.9 + $500 ==> $500.9

Revenue
Revenue is the total income a firm earns from the sale of its goods and services. The
more the sales, the more the revenue.
Total Revenue (TR) = No. of units sold (Sales) * Price per unit (P)
Average Revenue = Total Revenue (TR) / No. of units sold (Sales) (= Price per unit (P)!)
Suppose, from the example above, a TV is sold at $800 and the firm sells all the units it
produces, what is the firm’s Total Revenue and Average Revenue, for a month?
No. of units sold (Sales) in a month = No. of units produced in a month = 1000
Total Revenue = Sales * Price ==> 1000 * $800 = $800,000
Average Revenue = Total Revenue / Sales = $800,000 / 1000 = $800

Total Revenue – Total Cost = Profit

Objectives of Firms
Objectives vary with different businesses due to size, sector and many other factors.
However, many business in the private sector aim to achieve the following objectives.

 Survival: new or small firms usually have survival as a primary objective. Firms in a highly
competitive market will also be more concerned with survival rather than any other objective.
To achieve this, firms could decide to lower prices, which would mean forsaking other
objectives such as profit maximization.
 Profit: profit is the income of a business from its activities after deducting total costs from
total revenue. Private sector firms usually have profit making as a primary objective. This is
 because profits are required for further investment into the business as well as for
the payment of return to the shareholders/owners of the business. Usually, firms aim
to maximise their profits by either minimising costs, or maximising revenue, or both.
 Growth: once a business has passed its survival stage it will aim for growth and expansion.
This is usually measured by value of sales or output. Aiming for business growth can be very
beneficial. A larger business can ensure greater job security and salaries for employees. The
business can also benefit from higher market share and economies of scale.
 Market share: market share can be defined as the sales in proportion to total market sales
achieved by a business. Increased market share can bring about many benefits to the business
such as increased customer loyalty, setting up of brand image, etc.
 Service to the society: Some operations in the private sectors such as social enterprises do
not aim for profits and prefer to set more social objectives. They aim to better the society by
aiding society financially or otherwise.
A business’ objectives do not remain the same forever. As market situations change and as
the business itself develops, its objectives will change to reflect its current market and
economic position. For example, a firm facing serious economic recession could change its
objective from profit maximization to short term survival.