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The size of firms

Measuring and comparing the size of firms

The size of firms can be measured in a number of ways and these also provide useful clues about the reasons why some firms grow into very large organizations while others remain small.

  • Measure 1, number of employees: Firms with less than 50 employees are often classed as small. However, not all large firms employ many hundreds or thousands of workers. Some large firms employ relatively few workers, instead, they use a lot of machinery and equipment in order to produce large quantities of output.

  • Measure 2, organization: Larger firms are often divided up into different departments specializing in particular functions, such as purchasing, sales and marketing, etc. They may also have many different layers of management and different offices. In smaller firms the owners and employees tend to carry out all the various functions between them.

  • Measure 3, capital employed: Capital employed is money invested in those productive assets in a firm that help it generate revenue. They are assets used to produce and sell goods and services. The more capital employed in a firm the more it can produce and therefore the greater its size or scale of production. However, some large firms may be labour intensive. This means their production process requires the employment of a lot of workers but relatively little capital. 

  • Measure 4, market share: The market share of a firm measures the proportion of total sales revenue or turnover. But not all markets are so large. For example, a local hairdressing salon may be a very small business in terms of the number of people and amount of capital equipment it employs but it may have a very large share of the local market it serves because it is the only salon in a town.

Pages 240 and 241

How firms grow in size

There are two main ways a firm can grow in size and expand its scale of production.

Internal growth: Involves a firm expanding its scale of production through the purchase of additional equipment, increasing the size of their firms, and hiring more labour if needed. To finance this growth, the owners will need to use the profits of the firm, borrow money from banks or other lenders, etc. 

External growth: Involves one or more firms joining together to form a larger enterprise. This is known as integration through merger.

A merger occurs when the owners of one or more firms agree to join together to form a new larger enterprise. 

A takeover occurs when one company buys enough shares in the ownership of another so it can take overall control.

Alternatively, an entirely new company may be formed for the sole purpose of buying up shares in the ownership of a number of other companies. This is known as holding company.

Types of integration

Horizontal integration involves a merger or takeover of firms engaged in the production of the same type of good or service. The major criticism of firms linking horizontally is that very large firms are formed, which may be able to dominate their market. 

Vertical integration occurs between firms at different stages of production.

Backward integration can also occur between firms, but it’s not the same as horizontal integration since this one is not engaged in the production of the same type of good or service.

Lateral integration occurs between firms in different industries in the same stage or different stages of production. Lateral integration is also called conglomerate merge and forms firms called conglomerates because they produce a wide range of different products. 

Pages 242 and 244

Increasing the scale of production

When a firm expands the scale of production it has a chance to become more efficient and lower its average costs of production. Average or unit costs can be reduced as a firm grows in scale because it gives the management or owners a chance to reorganize the way the firm is run and financed. Such decisions are taken inside the firm and so the advantages or economies they bring are known as internal economies of scale, they will reduce the average cost of production each unit of output as the scale of production is expanded.

Types of economies of scale:

1. Purchasing economies: Large firms are often able to buy the materials, components and other supplies they need in bulk because of the large scale of their production. Suppliers will usually offer price discounts for bulk purchases because it is cheaper for them to make one large delivery than several smaller deliveries.

2. Marketing economies: Large business may buy or hire their own vehicles to distribute their goods and services rather than rely on other firms to do so. In this way a large firm can reduce its costs because it does not have to pay the profit margin of another supplier. + easy distribution.

3. Financial economies: Larger firms can often borrow more money and at lower interest rates than smaller businesses, since bank managers and other lenders often consider lending to big organizations as less risky than lending to smaller ones.

4. Technical economies: Larger businesses often have the financial resources available to invest on things that can really help the businesses, such as investing in specialized machinery and equipment, in training highly skilled workers, etc. while smaller firms may not be able to afford to do so.

5. Risk bearing economies: A large firm may have more customers, sell into more markets at home and overseas and offer a larger range of products than a smaller business.

diversification: producing a varied range of products and expanding into different consumer markets to reduce risk.

External economics of scale

Large firms may share external economies of scale which creates a rivalry between producers, as a result of their entire industry growing up. These may include:

– Large firms may have access to a skilled workforce because they can recruit workers trained by other firms in their industry.

– Ancillary firms develop and may locate nearby large firms in particular industries to provide them with specialized equipment and services they require. 

– There may be joint marketing benefits.

– Firms may benefit from shared infrastructure. The growth of an industry may persuade firms in other industries to invest in new infrastructure. 

Can firms grow too much?

The answer to this question is yes. However, many firms experience difficulties when they try to expand their size and scale of production too much and too quickly, and what they will get is going to be a fall in productivity, and the average costs will rise. These problems are caused by diseconomies of scale.

– Managing a large firm can be difficult, since there might be some communication breakdowns and disagreements between different managers in different parts of the organization, especially when talking about a business that has many locations, producing many types of products.

– Some very large firms may need vast quantities of materials, components, or power for production. They may experience shortages and this may hold up the production.

– Some large firms may be unable to attract enough workers with the right skills.

Labour diseconomies: workers might become de-motivated and less cooperative since they find boring repetitive tasks. Disputes and strikes may occur if workers feel poorly treated.

– Large firms may also find it difficult to continually attract new customers.

Agglomeration diseconomies can occur if a company takes over or merges with too many other firms producing different stages of production.

Pages 257 and 258

Pricing strategies

Setting the price of a good or service is a  difficult decision. If a firm sets the price of a product too high, consumers may be unwilling to buy the product, but if the price set is too low it may no cover the costs of production. If there is a lot of competition prices will need to be low enough to compete with other products. Government can aalso affect the final market prices, since any tariffs. value added, etc. will raise the final retail of products, in contrast, subsides paid to producers to reduce their total costs will alow them to lower the prices.

Three major factors will therefore influence the pricing decisions:

The level and strenght of consumer demand.

The amount of competition from rival producers to supply a market.

The costs of production and level of profit requested.

Demand-based pricing strategies involve setting prices according to how much consumers are willing to pay. Examples of pricing strategies:

– Price skimming: involves charging a high price to recover development costs and to yield a high initial profit from those consumers who are willing to pay more becuase the product is new or unique. As rival products are introduced, prices are lowered to increase sales and protect the market share.

-Penetration pricing: involves setting price low to encourage consumers to try a new product to expand sales and increase loyalty. If a firm is new to a market and if there are already well-established rival products.

Competitive pricing strategies

Agressive pricing strategies:

– Destruction pricing, is like penetration prices but involves much deeper shortcuts , in order to destroy the sales of a competitor.

– Price wars may develop in markets that are very competitive if one or more fims cut their prices.

– Price leadership may be used to avoid price wars because firms engaged in them all tend to lose money Instead firms will charge very similar prices and will rise them or lower theem together at the same time to avoid price competition.

Cost-based pricing

Cost-plus pricing involves calculating the average cost of producing each unit of output, and then addinng a mark-up profit. The problem with this is that it does not take into account what consumers may or may not be willing to pay, or how much competition there is to supply the market.

Price= (total cos/total output) + mark-up profit