Firms | IGCSE Class 10 Economics Notes

This note covers how firms are classified by sector and by size, why small firms exist alongside large ones, the advantages and limitations of staying small, how firms grow internally and externally, the main types of merger with their advantages and limitations, and how internal and external economies and diseconomies of scale affect a firm's costs as it changes its scale of production.

How are firms classified by sector and by size?

A firm is a business organisation that combines resources to produce goods or services. Firms are commonly classified by the sector of the economy in which they operate.

The primary sector extracts or gathers raw materials and natural resources, for example farming, fishing, forestry and mining.

The secondary sector takes those raw materials and manufactures or constructs them into finished or semi-finished goods, for example car assembly or house building.

The tertiary sector provides services rather than physical goods, for example retailing, banking, transport, education and healthcare.

Firms are also classified by whether they belong to the private sector or the public sector. A private sector firm is owned and run by private individuals or shareholders, usually with the main aim of making a profit.

A public sector organisation is owned and controlled by the government, and it may aim to provide a service that benefits society rather than to maximise profit.

Finally, firms differ enormously in relative size. Size can be measured in several ways, including the number of employees, the value of output produced, the amount of capital employed, and the firm's market share, its sales as a proportion of total sales in the industry.

In most economies, a very large number of firms are small, while a comparatively small number of firms are very large.

Why do small firms exist, and what are their advantages and limitations?

Many markets continue to contain a mixture of small and large firms side by side. Small firms survive for several reasons.

The size of the market they serve may itself be small or localised, so there is no room for a large-scale producer.

The owner may deliberately choose to stay small in order to keep personal control of the business rather than bring in outside investors or professional managers.

Some goods and services are best supplied on a small, personalised scale, such as hairdressing, bespoke tailoring or a local repair shop, where customers value individual attention.

Limited access to finance can also prevent a small firm from growing even if the owner wishes to expand.

Advantages of small firms

• Flexibility: a small firm can respond quickly to changes in customer taste because decisions are made by one owner or a small team.
• Personal service: the owner often deals directly with customers, building loyalty that a large firm may struggle to match.
• Lower overheads: a small firm may need little office space or management layers, keeping fixed costs low.
• Serving niche markets: small firms can profitably supply specialist products that are too small in volume to interest a large firm.

Limitations of small firms

• Limited access to finance, because banks and investors often see small, unlisted firms as higher risk.
• Inability to benefit fully from economies of scale, so average costs may be higher than those of larger rivals.
• Greater vulnerability to economic downturns, since a small firm usually has fewer reserves to absorb a fall in sales.
• Limited market power, which can leave a small firm a price taker rather than a price maker in its industry.

How do firms grow internally and externally?

A firm can increase in size in two broad ways. Internal growth, sometimes called organic growth, occurs when a firm expands using its own resources, for example by reinvesting profits to open new branches, widen its product range, or win a larger market share from rivals through more competitive pricing or advertising.

Internal growth tends to be gradual, because it depends on the firm's own sales and profits.

Why do firms want to grow? Common causes of growth are the wish to earn higher profits, to win a larger market share and more market power, to gain economies of scale that lower average costs, and to spread risk by selling a wider range of products or selling in more markets.

External growth occurs when a firm combines with, or takes over, another firm, most commonly through a merger. External growth can increase a firm's size far more quickly than internal growth, because it brings together the assets, customers and output of two separate businesses in one step.

What are mergers, and what are their advantages and limitations?

A merger happens when two or more previously separate firms combine to form a single firm. Mergers are usually classified by the relationship between the merging firms.

Definition: merger. The combining of two or more firms into a single firm, used as a form of external growth.

Horizontal mergers

A horizontal merger joins two firms in the same industry at the same stage of production, for example two car manufacturers merging.

The main advantages are an increase in market share and the ability to benefit from economies of scale, because fixed costs such as machinery or head-office costs can be spread over a larger combined output.

The main limitations are a reduction in competition and consumer choice, possible redundancies, and the risk that the combined firm gains so much market power that it behaves like a monopoly.

Vertical mergers

A vertical merger joins two firms in the same industry but at different stages of production.

A backward vertical merger joins a firm with one of its suppliers, for example a car manufacturer merging with a steel supplier, which can secure the supply and quality of raw materials.

A forward vertical merger joins a firm with a business nearer the final customer, for example a car manufacturer merging with a chain of dealerships, which can secure an outlet for the firm's output.

Limitations include the risk of raising barriers to entry for rival firms and the management difficulty of running businesses at very different stages of production.

Conglomerate mergers

A conglomerate merger joins firms in unrelated industries, for example a food manufacturer merging with a clothing retailer.

The main advantage is that it spreads risk, because poor trading conditions in one market can be offset by stronger trading in another.

The main limitation is that the firm's managers may lack expertise in the newly acquired industry, which can lead to a loss of focus and integration difficulties.

What are economies and diseconomies of scale?

As a firm increases its scale of production in the long run, when all factors of production can be varied, its average cost of production does not stay the same.

A proportionate increase in all inputs can lead to output rising by a larger proportion, the same proportion, or a smaller proportion.

When output rises by a larger proportion than inputs, this is called increasing returns to scale; when output rises by the same proportion, this is constant returns to scale; and when output rises by a smaller proportion, this is decreasing returns to scale.

These patterns underlie economies and diseconomies of scale: as long as increasing returns to scale operate, the firm's long-run average cost falls as output rises, and this fall in long-run average cost as the scale of production increases is called an economy of scale.

Once decreasing returns to scale set in, long-run average cost rises as output rises, and this rise is called a diseconomy of scale.

A firm's long-run average cost curve is typically U-shaped, falling at first, reaching a minimum, and then rising again.

Definition: economies of scale. The fall in a firm's long-run average cost as it increases its scale of production.

Definition: diseconomies of scale. The rise in a firm's long-run average cost that may occur once the firm grows beyond a certain scale of production.

Draw output on the horizontal axis and cost on the vertical axis. Sketch a U-shaped long-run average cost curve that falls while internal economies of scale dominate, reaches a minimum point, and then rises as internal diseconomies of scale set in.

Internal economies and diseconomies of scale

Internal economies of scale arise from the growth of the individual firm itself, regardless of what happens to the rest of the industry.

Common types include purchasing economies, from bulk-buying raw materials at a discount; technical economies, from using large-scale, specialised machinery; managerial economies, from employing specialist managers for each department; financial economies, from being able to borrow more easily and at lower interest rates; and marketing economies, from spreading advertising and distribution costs over a much larger output.

Internal diseconomies of scale can appear once a firm grows beyond an efficient size. Common causes include communication problems, as messages take longer to pass through more layers of management; coordination and control difficulties, as it becomes harder for managers to monitor every part of a very large organisation; and falling worker motivation, if employees feel like a small, anonymous part of a huge organisation.

External economies and diseconomies of scale

External economies of scale arise when the whole industry grows, particularly when many firms in the same industry cluster in one area, and the benefits are available to every firm in that industry, not just to one firm that grows.

Examples include a local pool of workers already skilled in the industry, specialist local suppliers of components or services, and improved local infrastructure such as roads or ports built to serve the industry.

External diseconomies of scale can appear if an industry becomes too concentrated in one area.

Growth of the industry can push up local costs for every firm, for example through traffic congestion, competition for scarce local labour, or rising local land prices, so that average costs rise for firms across the whole industry rather than for just one firm.

Glossary

• Primary sector — the part of the economy that extracts or gathers raw materials and natural resources, such as farming or mining.
• Secondary sector — the part of the economy that manufactures or constructs finished and semi-finished goods from raw materials.
• Tertiary sector — the part of the economy that provides services, such as retailing, banking or education, rather than physical goods.
• Private sector — firms owned and run by private individuals or shareholders, usually to make a profit.
• Public sector — organisations owned and controlled by government, which may aim to provide a service rather than maximise profit.
• Market share — a firm's sales as a proportion of total sales in its industry, used to measure its relative size.
• Internal growth — a firm increasing in size using its own resources, for example by reinvesting profits or winning more customers.
• External growth — a firm increasing in size by combining with, or taking over, another firm, usually through a merger.
• Merger — the combining of two or more previously separate firms into a single firm.
• Horizontal merger — a merger between two firms in the same industry at the same stage of production.
• Vertical merger — a merger between two firms in the same industry at different stages of production, backward towards a supplier or forward towards the customer.
• Conglomerate merger — a merger between firms in unrelated industries, mainly to spread risk.
• Economies of scale — the fall in a firm's long-run average cost as its scale of production increases.
• Diseconomies of scale — the rise in a firm's long-run average cost that may occur once production grows beyond an efficient scale.

Common errors and misconceptions

• Misconception: all small firms want to grow as large as possible. Correct: many owners deliberately keep a firm small to retain personal control or because the market they serve is itself small.
• Misconception: a merger is the same as internal growth. Correct: a merger is a form of external growth, combining two separate firms, while internal growth uses only the firm's own resources.
• Misconception: all mergers join firms in the same industry. Correct: a conglomerate merger joins firms in unrelated industries, mainly to spread risk.
• Misconception: economies of scale and diseconomies of scale are the same thing. Correct: economies of scale lower long-run average cost as output rises, while diseconomies of scale raise it once the firm grows beyond an efficient size.
• Misconception: economies of scale only benefit the firm that grows. Correct: internal economies benefit only the growing firm, but external economies of scale benefit every firm in an industry that grows or clusters together.
• Misconception: a backward and a forward vertical merger are the same. Correct: a backward vertical merger is with a supplier, while a forward vertical merger is with a business nearer the final customer.
• Misconception: firm size can only be measured by the number of employees. Correct: size can also be measured by output, capital employed or market share, and these measures do not always agree.

Exam-style questions with model answers

Q1. Identify two features used to classify firms. [2 marks]

1. Answer: Two features used to classify firms are: the sector of the economy in which they operate, namely the primary, secondary or tertiary sector; and whether they are in the private sector, owned by individuals or shareholders for profit, or the public sector, owned and controlled by government.

Q2. Explain one reason why a firm may remain small. [3 marks]

1. Answer: A firm may remain small because the size of the market it serves is limited, for example a specialist local baker or a village shop has only a small number of regular customers. Producing on a larger scale in such a market would create output that the firm could not sell, so staying small matches the firm's output to the available demand.

Q3. Explain two advantages of a horizontal merger to a firm. [4 marks]

1. Answer: One advantage is that a horizontal merger increases the firm's market share, because the merged firm serves the combined customers of both original firms, giving it greater influence over price and output in the industry. A second advantage is that the firm can benefit from economies of scale, because combining production allows fixed costs, such as machinery or head-office costs, to be spread over a much larger output, lowering average cost.

Q4. Explain two methods of internal growth available to a firm. [4 marks]

1. Answer: One method is increasing market share by winning customers from rivals through more competitive pricing or advertising, which raises sales using the firm's own resources rather than combining with another business. A second method is reinvesting profits to open new branches or to widen the existing product range, allowing the firm to expand gradually using money it has already earned.

Q5. Analyse how internal economies and internal diseconomies of scale affect a firm's long-run average cost as its output increases. [6 marks]

1. Answer: As a firm first increases its scale of production, it can gain internal economies of scale, including purchasing economies from bulk-buying raw materials, technical economies from using large-scale machinery, managerial economies from employing specialist managers, financial economies from cheaper access to borrowing, and marketing economies from spreading advertising costs over a larger output. These economies cause the firm's long-run average cost to fall as output rises, corresponding to increasing returns to scale, where a proportionate increase in inputs leads to a larger proportionate increase in output. Beyond a certain scale, however, internal diseconomies can appear: communication problems as messages pass through more layers of management, difficulties of coordination and control across a very large organisation, and falling worker motivation. These diseconomies cause long-run average cost to rise again, corresponding to decreasing returns to scale. The result is a U-shaped long-run average cost curve, falling while economies of scale dominate, reaching a minimum where returns to scale are constant, and then rising as diseconomies of scale set in.

Q6. Discuss whether a small firm should merge with a larger rival in the same industry. [6 marks]

1. Answer: Merging with a larger rival could benefit the small firm because a horizontal merger would increase its market share and allow it to share in economies of scale, such as bulk-buying discounts and specialist management, lowering its average costs and improving its ability to compete on price. The merger could also give the small firm access to the larger firm's finance and distribution network. However, the merger has drawbacks: the small firm's owner would likely lose personal control over decisions, and if the merger reduces competition sharply, it could also attract scrutiny for reducing consumer choice. There is also a risk of internal diseconomies of scale if the combined firm becomes difficult to coordinate. On balance, the firm should weigh the likely cost savings and security of a larger scale against the loss of independence and the risk of coordination problems, and the decision depends on how competitive the market is and how much the owner values control over growth.

Q7. State two examples of internal diseconomies of scale. [2 marks]

1. Answer: Two examples of internal diseconomies of scale are communication problems between departments as a firm becomes very large, which can make decisions slower; and difficulties of coordination and control, because managers find it harder to monitor every part of a very large organisation.

Key takeaways

• Firms are classified by the primary, secondary or tertiary sector they operate in, and by whether they are private sector or public sector.
• Firm size can be measured by employees, output, capital employed or market share, and most firms in an economy are small.
• Small firms can survive because of limited local demand, an owner's wish to keep control, or the need for personalised service.
• Small firms gain from flexibility and personal service but suffer from limited finance and weaker market power than large rivals.
• Internal growth uses a firm's own resources; external growth combines the firm with another firm, usually through a merger.
• Horizontal mergers join firms at the same stage in the same industry; vertical mergers join different stages of the same industry; conglomerate mergers join unrelated industries.
• Economies of scale lower a firm's long-run average cost as output rises; diseconomies of scale raise it once the firm grows too large.
• Internal economies and diseconomies affect one growing firm; external economies and diseconomies affect every firm in a growing industry.
• A typical long-run average cost curve is U-shaped, falling with increasing returns to scale and rising with decreasing returns to scale.

Test yourself

What is the difference between the primary, secondary and tertiary sectors?

The primary sector extracts raw materials, the secondary sector manufactures or constructs goods from them, and the tertiary sector provides services rather than physical goods.

Give one reason a firm might prefer to remain small rather than grow.

The owner may wish to keep personal control of the business, or the market served may be too small or specialised to support a larger scale.

What is the difference between internal growth and external growth?

Internal growth uses the firm's own resources, such as reinvested profits, while external growth combines with another firm, usually through a merger.

Distinguish between a horizontal and a vertical merger.

A horizontal merger joins firms at the same stage of the same industry, while a vertical merger joins firms at different stages of the same industry.

Why might a conglomerate merger reduce a firm's risk?

Because the merged firm operates in unrelated industries, poor trading in one market can be offset by stronger trading in another.

What happens to long-run average cost when internal economies of scale operate?

Long-run average cost falls as output increases, because the firm benefits from lower costs per unit from sources such as bulk-buying or specialist machinery.

Give one example of an internal diseconomy of scale.

Communication problems between departments, or difficulties of coordination and control, as a firm grows beyond an efficient size.

How do external economies of scale differ from internal economies of scale?

External economies benefit every firm in a growing industry, such as a skilled local workforce, while internal economies benefit only the individual firm that grows.