Firms

Classification of firms

Firms can be classified based on the following:

1. Stage of production(primary, secondary, or tertiary)
2. Ownership(private or public sector)
3. Size of firm(value of output/number of workers employed/financial capital employed)

Factors affecting the size of a firm:

1. Age of the firm
2. availability of financial capital
3. Type of business organization – MNC or shop owner
4. Internal economies and diseconomies of scale – to be discussed later
5. Size of the market.

Why do some firms choose to remain small?

1. The small size of the market
2. Preference of customers
3. Owner’s preference
4. Flexibility
5. Technical factors – some industries require very little capital and hence make it easy for new firms to set up
6. Lack of financial capital
7. Cooperation between small firms – e.g. small farmers
8. Government support

Firms’ Growth

1. Internal growth (natural growth) – this type of growth may occur through increasing the size of existing plants or opening new ones.
2. External growth – this involves firms joining with another firm(s) to form one firm through a merger or takeover. 

Horizontal merger

A horizontal merger is the merger of two firms at the same stage of production. E.g. – a merger of two car companies or two TV companies.

Motive for merger:

1. Achieve economies of scale – lower unit costs
2. Larger market share
3. Eliminate a direct competitor
4. Rationalization – eliminating unnecessary equipment and plants to make a firm more efficient.

Risks:

1. New firms will be too large to control – diseconomies of scale
2. Difficult to integrate two firms

Vertical merger

A vertical merger occurs when a firm merges with another firm producing the same product but at different stages of production. It can be vertically backward or vertically forward.

Vertical backward – when a firm merges with another firm which is the source of its raw materials or components. E.g. – a tire manufacturing firm merging with a producer of rubber.

Motive for merger

1. Ensure adequate supply of good raw materials.
2. Restrict access to raw materials to rival firms

Vertical forward – when a firm merges or takes over a market outlet. E.g. – oil companies buying petrol stations.

Motives for merger

1. There are sufficient outlets and products and products are stored and displayed in quality outlets
2. For the development and marketing of new products 

Problems with vertical Mergers

1. Management problems – managers of merged firms may not be familiar with running, for instance, a market outlet.
2. Mergers of firms of different sizes might lead to the need for some adjustments. Eg – supplies might be bought from other firms if the supplier with whom the merger occurs is smaller in size.

Conglomerate merger

It is a merger between two firms making different products. Eg – an electricity company merging with a travel company.

Motive for merger

1. Diversification – such a merger spreads the firm’s risks and enables it to continue its growth, even if the market for one product is declining.

Risk

1. Coordinating a firm producing a range of products can be challenging.

Economies of scale

• Economies of scale are the advantages, in the form of lower long-run average costs (LRAC) of producing on a larger scale. 

• Internal economies of scale are the advantages gained by an individual firm by increasing its size. 

• External economies of scale are the advantages gained by all firms in an industry from the growth of the industry.

• Diseconomies of scale are the disadvantages of ‘being too large’, in terms of LRAC.

• Internal diseconomies of scale are disadvantages acquired by an individual firm by increasing its size too much. 

• External diseconomies of scale are the disadvantages acquired by all firms in an industry obtained due to the industry experiencing overgrowth.

Internal economies and diseconomies of scale

As a firm changes its scale of operation, its average costs are likely to change. The figure shows the usual U-shaped LRAC curve. Average costs fall at first, reach an optimum point, and then rise. 

Forms of internal economies of scale:

1. Buying economies
2. Selling economies
3. Managerial economies
4. Labor economies
5. Financial economies
6. Technical economies
7. Research and development economies
8. Risk bearing economies

Forms of external economies of scale 

1. A skilled labor force
2. A good reputation
3. Specialist suppliers of raw materials and capital goods
4. Specialist services by service providers, for example – transport and banks.
5. Specialist markets
6. Improved infrastructure

Forms of internal diseconomies of scale:

1. Controlling the firms becomes challenging- as firms grow, more layers of management are necessary and hence increased administrative costs. 
2. Communication problems- In large firms, if communication is not extremely effective then many misunderstandings could arise and hence decreased efficiency. 
3. Poor industrial relations- workers receive less recognition in large firms and may lose motivation and hence decrease efficiency.

Forms of external diseconomies of scale

1. Congestion
2. Increased journey time
3. Higher transport cost 
4. Reduced workers’ productivity
5. Increased competition for resources
6. The inflated price of capital, sites, and labor.