FIRMS AND PRODUCTION

A firm is a unit of an industry that specializes in the production of a product or provision of service.

An industry is a combination or group of firms that produce the same or similar product or service.

Classification of Firms

Firms can be classified into:

i. The sector of the economy in which they operate

ii. Publicly (government) or privately owned
iii. Their relative size

The Economic Sector

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

➢ The primary sector includes firms involved in the production or extraction of raw materials e.g. fishing, farming,
mining
➢ The secondary sector includes firms that process raw materials in order to manufacture goods. Their activities
include manufacturing, assembling and construction.
➢ The tertiary sector includes firms which provide services. 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.

Public or Private Sector Firms

➢ Public Sector Firms: They include 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 Sector Firms: They include 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.

The relative size of firms

The relative size of firms can be used as a way of classifying them into small, medium and large firms. Firms can be
classified by their relative size in four different ways:
 ➢ the number of workers employed by a firm
➢ the value of output/sales over a period of time, for example, one year
➢ the percentage share of a market controlled by a firm
➢ the value of the capital employed by a firm, that is, the value of its assets.

SMALL FIRMS

There is no one agreed definition of a small firm, but as an example, it could be described in the following ways.

Number of employees: a small firm might be one employing less than 50 workers.

Value of output: a small firm might be one selling less than US$6.5 million of products in a year:

Market share: a small firm might be one with less than a 5% share of a market.

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 and Disadvantages of Small Firms

The Advantages of Small Firms

• They are major employers in an economy.

• They provide many of the raw materials and component parts for larger firms.
• They provide goods and services to the local economy; e.g. local shops can sometimes exist in areas where larger
firms do not operate.
• They are usually very flexible and can supply what customers want, providing a quality service based on good
relationships with customers. This can make them more effective than large firms.
• They provide new enterprise and dynamism in an economy.
• They provide opportunities for people who want to work for themselves.

Disadvantages of Small Firms

• They will usually have limited production capacity and will not be able to meet a large demand for their products.
• Small firms are usually unable to benefit from the cost advantages that large firms have (known as economies of
scale).
• They can sometimes find it difficult to raise sufficient capital to finance the expansion of the firm.
 • They often do not have access to the research and development facilities that large firms have and this may limit
their ability to make use of new technology and limit scope for product innovation.
• They are likely to be less well known than large firms because they only have a limited marketing budget.

Challenges Facing Small Firms

Small firms face a number of challenges, including:

• lack of capital to finance expansion

• managers who lack the necessary knowledge and experience
• inability to supply products on a large scale
• inability to benefit from the cost advantages offered by economies of scale.

Reasons for the Existence of Small Firms

There a number of reasons why a firm may be small. They include:

• Some small firms have just been set up.

• The owners of a small firm may prefer it to remain small, making it easier to manage.
• The size of the market may be small so there is only a limited demand for the firm's products, for example, where
a small firm is supplying specialised, niche products.
• A small firm may not be able to raise sufficient funds to finance expansion.
• Small firms may be able to receive grants and other forms of financial support from a government.
• The firm is providing customers with a service that requires personal attention, for example, hairdressing.
• Small firms are likely to be more flexible in responding to changes in demand.
• Small firms may be more innovative and pioneering.
• In some industries, there has been an increase in contracting out and small firms may benefit from this.
• A small firm may be more efficient; its labour relations and levels of motivation may be better than
in a large firm.

CAUSES AND FORMS OF THE GROWTH OF FIRMS

Reasons for the Growth of Firms

The growth of firms can come about through internal growth or external growth, such as through a merger, a takeover or
an acquisition. Firms may wish to grow in size for a number of different reasons.

1. They may be able to reduce the costs of production by benefiting from economies of scale.
2. They may be able to gain a larger share of a market.
 3. They may be able to develop new and improved products.
4. They may be able to sell to new markets, perhaps in other countries.
5. They may become stronger and more secure as a result of growth.
6. They may be able to increase the profitability of the firm.

INTERNAL GROWTH

Internal growth is the growth of a firm that comes about through internal expansion (also known as organic growth)

Internal growth can come about in a number of different ways:

• reinvesting or ploughing back some of the profits of the firm

• requesting the owners, the shareholders, to put in more capital to provide more funds to finance expansion
• operating a franchise arrangement where the firm (the franchisor) allows another business (the franchisee) to use
its business idea in return for a share of the profit made by the other business. Franchise: an arrangement whereby
one firm gives the right to another firm to supply its products.
• opening new stores or retail outlets so that there is a rolling out' to multiple outlets under the ownership and
control of the firm
• developing e-commerce to allow the firm to create an online trading platform so that a website can be used to
expand to a much larger market
• outsourcing to enable the firm to contract out some of its work to another firm which will then make goods or
provide services on the firm's behalf.

EXTERNAL GROWTH

External growth is the growth of a firm that comes about by joining together with other businesses

External growth can come about in a number of different ways.

• There can be a merger with another firm to form a single business. Merger is an agreement between two or more
firms to join together to create a single enterprise
• There can be a takeover of another firm. Takeover is the purchase of 51% or more of the shares of another firm in
order to take over control of that business
• There can be an acquisition of part of another firm. Acquisition is a situation where a firm gains control of part of
another business.

TYPES OF MERGERS

1. Vertical integration (forward or backwards)

 2. Horizontal integration
3. Conglomerate integration

VERTICAL INTEGRATION

Integration/merger 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).

Backward vertical integration: when a firm integrates with a firm that is at an earlier stage of production than theirs.
Acquisition/merger takes place towards the source of raw materials. Example: a chocolate retailer integrates with a
chocolate manufacturing company.
Forward vertical integration: when a firm integrates with a firm that is at a later stage of production than theirs.
Acquisition/merger takes place towards the market for the final products. Example: a dairy farm integrates with a cheese
manufacturing company.

Advantages of Vertical Integration

1. Reduces the cost of production as middle man profits are eliminated

2. Lower costs make the firm more competitive
3. Greater control over the supply chain reduces risk as access to raw materials is more certain
4. Quality of raw materials can be controlled
5. Forward integration adds additional profit as the profits from the next stage of production are assimilated
6. Forward integration can increase brand visibility

Disadvantages of Vertical Integration

1. Diseconomies of scale occur as costs increase e.g. unnecessary duplication of management roles
2. There can be a culture clash between the two firms that have merged
3. Possibly little expertise in running the new firm results in inefficiencies
4. The price paid for the new firm may take a long time to recoup

HORIZONTAL INTEGRATION

This refers to the 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 of Horizontal Integration

1. Rapid increase of market share

2. Reductions in the cost per unit due to economies of scale
3. Reduces competition
4. Existing knowledge of the industry means the merger is more likely to be successful
5. Firm may gain new knowledge or expertise

Disadvantages of Horizontal Integration

1. Diseconomies of scale may occur as costs increase e.g. unnecessary duplication of management roles
2. There can be a culture clash between the two firms that have merged
 LATERAL/CONGLOMERATE INTEGRATION

This occurs when firms producing different type of products integrate. It occurs when two or more firms from different
industries merge. 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 of a Conglomerate Integration

1. Reduces overall risk of business failure

2. Increased size & connections in new industries opens up new opportunities for growth
3. Parts of the new business may be sold for profit as they are duplicated in other parts of the conglomerate

Disadvantages of a Conglomerate Integration

1. Possible lack of expertise in new products/industries

2. Diseconomies of scale can quickly develop
3. Usually results in job losses
4. Worker dissatisfaction due to unhappiness at the takeover can reduce productivity

ECONOMIES AND DISECONOMIES OF SCALE

Economies of Scale

Economies of scale refer to the cost advantage experienced by a firm when it increases its level of output. In an economy
of scale, a larger output can be produced at a lower unit cost. These economies can be of two types; internal economies
and external economies of scale.

Internal economies of scale

They are the cost advantages that a particular firm gains from its own increase in output. Some internal economies of scale
are:

1. Purchasing economies: large firms can 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.
2. 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.
3. 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.
4. 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.
 5. 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

They are cost advantages that all firms in an industry gain. Some internal economies of scale are:

1. 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.
2. 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.
3. Transport Links: Improved transport links develop around growing industries in order to help get people to
work & to improve the transport logistics. This will cut distribution costs.
4. Joint marketing benefits: when firms in the same industry locate close to each other, they may share an
enhanced reputation and customer base.
5. 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

Whereas economies of scale refer to the lowering of average costs, diseconomies of scale refer to the increase of average
costs. As with economies of scale, diseconomies of scale are of two types:

➢ internal diseconomies of scale: the cost disadvantages that a particular firm experiences from its own increase in
output
➢ external diseconomies of scale: the cost disadvantages that all firms in an industry experience.

Internal diseconomies of scale

There are many different types of internal diseconomies of scale.

1. Management problems: If a firm grows too large, management of the firm may become less effective.
2. Technical problems: A large firm may also experience technical problems as it buys new capital equipment.
3. Failure to sell output: If a large firm is producing more that it can sell, the proportion of advertising costs may
become too high, increasing the average cost of production.
 4. Industrial relations disputes: Industrial relations disputes, such as strikes, are more likely to occur in large
firms.

External diseconomies of scale

There are also many different types of external economies of scale.

1. Cost of labour and other factors: It is possible that as an industry grows, the cost of labour could increase as the
supply of skilled, specialised labour reduces. The cost of land may also increase as demand exceeds supply,
pushing up rents.
2. Congestion: There will be an increase in transport, increasing congestion, leading to higher transport costs as
journey times are increased.
3. Pollution: There may also be increased pollution, both in terms of noise pollution and air pollution.
4. More expensive housing: The cost of housing may increase, putting workers off relocating to an area.