Chapter 20 – Firms

1. Classification of firms

Firms can be classified in different ways. The three most common ways are by economic sector, by ownership and by relative size.

Classification by economic sector

Sector	Meaning	Examples
Primary sector	Firms that extract or collect natural resources.	Farming, fishing, mining, forestry.
Secondary sector	Firms that manufacture or construct goods using raw materials.	Car production, food processing, house building.
Tertiary sector	Firms that provide services rather than physical goods.	Banking, retail, education, healthcare, transport.

Classification by public and private sectors

Classification by relative size

The size of a firm can be measured in different ways. No single method is perfect, so economists often use more than one measure.

• Number of employees: how many workers the firm employs. This is easy to measure, but a firm with few workers and many machines can still be very large.
• Market share: the percentage of total market sales controlled by the firm. A high market share means the firm is important in that market.
• Sales revenue: the value of goods and services sold by the firm. This shows how much money the firm receives from sales.
• Market capitalisation: the total value of a company’s shares. It is calculated as share price multiplied by the number of shares.

2. Small firms

Small firms can survive even when large firms exist. This is because not every customer wants the cheapest mass-produced product. Some customers prefer personal service, local convenience, specialist products or flexible businesses that understand their needs.

How small firms coexist with larger firms

• Niche markets: small firms may sell specialist products that large firms do not focus on.
• Personal service: customers may prefer a local shop, tutor, barber or repair service because the service feels more personal.
• Flexibility: small firms can make decisions quickly and adapt to local demand.
• Lower overheads: some small firms have lower rent, fewer managers and simpler organisation.
• Subcontracting: large firms may give work to small specialist firms instead of doing everything themselves.

Small firms: advantages and disadvantages

3 advantages	3 disadvantages
Personal customer service – owners may know customers well and respond to their needs.	Limited finance – small firms may struggle to borrow money or invest in expansion.
Quick decisions – fewer layers of management mean decisions can be made faster.	Higher average costs – they may not benefit from large economies of scale.
Flexible and specialised – they can focus on local or niche markets.	More vulnerable – one bad period, strong competitor or cash-flow problem may threaten survival.

3. Causes of growth

Firms may grow to increase profits, reduce average costs, gain market share, enter new markets or become more secure against competitors.

Mergers, takeovers and franchising

• Merger: two firms agree to join together and become one larger firm.
• Takeover: one firm buys control of another firm.
• Franchising: a business allows another person or firm to use its brand name, products and business model in return for fees or a share of revenue.

4. Types of mergers

Type of merger	Meaning and example	2 benefits	2 limitations
Horizontal merger	Two firms at the same stage of production in the same industry join together. Example: two supermarkets merge.	Greater market share; economies of scale such as bulk buying.	May reduce consumer choice; may be blocked by competition authorities.
Vertical merger	Firms at different stages of production in the same industry join together. Example: a chocolate manufacturer buys a cocoa supplier.	More control over supply or distribution; lower costs by removing middle businesses.	Can be expensive to manage; the firm may lack expertise in the new stage of production.
Conglomerate merger	Firms in completely different industries join together. Example: a food company buys a hotel chain.	Spreads risk across different markets; gives access to new customers and revenue sources.	Managers may not understand the new industry; the business may become too complex to control well.

5. Economies of scale

Economies of scale happen when a firm’s average cost falls as output increases. Average cost means cost per unit. For example, if a large bakery buys flour in bulk, the cost of flour per loaf may fall.

Internal economies of scale

Internal economies of scale are cost advantages gained because the firm itself grows larger.

• Bulk-buying economies: large firms can buy materials in large quantities at lower prices.
• Technical economies: large firms can afford advanced machinery that lowers cost per unit.
• Financial economies: large firms may borrow money more cheaply because banks see them as less risky.
• Managerial economies: large firms can employ specialist managers for finance, marketing and operations.
• Marketing economies: advertising costs can be spread over a larger number of units sold.

External economies of scale

External economies of scale are cost advantages gained when the whole industry or area grows, not just one firm.

• Skilled labour: workers with relevant skills may become available in the area.
• Specialist suppliers: suppliers may locate nearby and reduce delivery costs.
• Better infrastructure: roads, ports, internet and power supply may improve as the industry expands.
• Shared knowledge: firms may learn from each other when they operate close together.

Diseconomies of scale

Diseconomies of scale happen when a firm becomes so large that average costs start to rise. Growth is not always good if the business becomes difficult to control.

• Communication problems: messages may become slow or unclear in a very large firm.
• Poor coordination: departments may not work smoothly together.
• Low staff morale: workers may feel ignored in a very large organisation.
• Loss of control: senior managers may find it difficult to monitor all workers, branches and departments.