3.1.1 Sizes and types of firms

Why do firms want to grow? (5)

• Economies of scale → Lower average costs and higher profits 
• Diversification and reinvestment → Wider range of products, less of an impact if demand for one product falls 
• Owners/managers incentives → Owners make higher profits and managers are rewarded with higher salaries
• Shareholder incentives → dividends and share prices 
• Market power → Larger firms have power to increase prices as they have fewer competitors, demand is more inelastic

Why do some firms not feel the need to grow? (5)

• Local monopoly → high profits in an area

• Niche market

• Avoid the principal agent problem

• Personal service → degree of monopoly power as they provide a more unique + local service

• Diseconomies of scale

What is the principal agent problem?

• Divorce of ownership from control 

• Agents maximise their own benefits at the expense of the principal

• Managers have an inventive to appropriate profits by

  • Awarding themselves large pay packages and bonuses

  • Grow the company to maximise size at the expense of profit

Why does the principal agent problem occur + why do managers want to sales max?

• Salaries and bonuses tend to depend on revenue or sales, rather than profitability

• So to maximise their bonuses, they will maximise sales, not profits 

• But shareholders would rather profit maximise, so their share increases in value

How is the principal agent problem mitigated? (2)

• Shareholders exercise power at the Annual General Meeting (AGM)

• They have the power to vote directors off the board if they are not prioritising profit

What are the problems with Annual General Meetings?

• Asymmetric information - shareholders cannot scrutinise managers constantly 

• There is a 'free rider problem'. No incentive for shareholders to spend resources monitoring the firm as they can enjoy the profits if someone else does it. Everyone free rides on everyone else

• Directors might have strong influence 

What are the ways of measuring a firm’s growth?

• Change in

  • Profits

  • Units sold

  • Revenue

  • Employees

Define Public Sector (2)

• When the government (both central + local) has control of an industry, e.g. the NHS + the UK railway industry

• Aims to maximise welfare

What are the benefits of the public sector? (2)

• Yield strong positive externalities, e.g. using public transport + congestion and pollution are reduced

• Social welfare might be a priority of a public sector industry. It could also lead to a fairer distribution of resources

Define Private Sector (2)

• When a firm is owned and run by individuals or groups of individuals, e.g. British Airways

• Aims to maximise profit

What are the benefits of the private sector? (3)

• Incentivises firms to operate efficiently, which increases economic welfare

• Increases allocative efficiency + increased quality of goods

• Competition may also lead to lower prices

How do the benefits of both private + public sector firms relate to one another?

The benefits of the private sector are what the public sector lacks + vice versa

For-Profit-Firms (2)

• A profit organisation aims to maximise the financial benefit of its shareholders and owners

• The goal of the organisation is to earn maximum profits

Not-For-Profit-Firms (2)

• A not-for-profit organisation has a goal which aims to maximise social welfare

• They can make profits, but they cannot be used for anything apart from this goal and the operation of the organisation