3.1.1 sizes and types of firms

Why do some firms tend to remain small?

Some firms remain small because of constraints on growth: the size of the market, access to finance, owner objectives and govt support. Not all firms want to grow,

Why do some firms grow?

Some firms grow because

• they will be able to experience economies of scale

• gain monopoly power

• for greater security

• diversification,

• managerial objectives

• survival.

Why does experiencing economies of scale a reason why firms want to grow?

By growing, a firm will be able to experience economies of scale, which helps them to decrease their costs of production. They will be able to sell more goods, so make more revenue. Together, these a firm will make a larger profit (many firms are motivated by profit).

Why is gaining monopoly power a reason why firms want to grow?

A larger firm will hold a greater share of their market, so ability to influence prices and restrict the ability of other firms to enter the market, helping them to make profits in the LR. Monopoly power means firms have monopsony power, so able to reduce their costs by driving down the prices of their raw materials.

Why is greater security a reason why firms want to grow?

A larger firm means greater security, as they will be able to build up assets and cash which can be used in financial difficulties. Also, likely to sell a bigger range of goods in more than one local/national market, so less affected by changes to individual products or places.

What is the separation/divorce of ownership and control?

In many large firms, there is separation/ divorce of ownership and control.

• Firms are owned by their shareholders, who play no part in the day to day running of the business.

• The chief executive and senior managers control day-to-day decision-making.

• Shareholders are represented by a board of directors, who oversee the way the business is run. They are able to vote directors onto and off the Board of Directors at the AGM → a mandatory yearly gathering that publicly traded companies (and some organisations) must hold for their shareholders.

• However, this often makes little difference, and shareholders have more power through buying and selling shares: if share prices drop significantly, the board may be encouraged to change their strategy.

What are the problems of separation of ownership and control?

This separation causes problems due to the differing aims of the 2 stakeholders

• the owners will want to maximise the returns on their investment, so they will want to short-run profit maximise

• However, directors and managers are unlikely to want the same thing: as employees, they will want to maximise their own benefits

What is the principal agent problem?

Owners/shareholders are the principals and managers are the agents who run the business on their behalf.

A problem arises because:

• different objectives→

  • owners/shareholders want to profit maximise

  • managers want higher salaries, perks, job security or sales growht(empire building)

• The result can be profit satisficing rather than profit maximising.

pmt= The principal agent problem, where one group, the agent, makes decisions on behalf of another group, the principal.

In theory, the agent should maximise the benefits for those whom they are looking after, but in practice, agents have the temptation to maximise their own benefits. It is for this reason that many firms are not run to profit-maximise but to profit-satisfice, a concept looked at in unit 3.2.

The issue could be overcome by giving managers shares in the business or linking their bonuses to profits; this will mean that they personally will gain from higher profits.

What is the private sector?

Private sector= part of the economy that is owned and run by individuals or groups of individuals, including sole traders and PLCs. Their main objective is usually profit. They are funded by sales revenue, loans, share capital.

UK examples= Tesco, BT, Unilever

What is the public sector?

Public sector= part of the economy which is owned or controlled by local or central government. Their main objectives are social welfare, providing merit and public goods, often loss-making. They are funded by taxation, govt borrowing

UK examples= NHS, Network Rail, BBC, Channel 4

pmt= The purpose of these organisations is to provide a service for UK citizens and profit-making is not their main aim; some may even make a loss which is funded for by the taxpayer

What organizations can the private sector be split into?

The private sector can be split into profit and not-for-profit organizations.

What are profit organisations?

Almost all private sector organisations are run to make a profit and to maximise the financial benefits for their shareholders. They may not necessarily profit-maximise, but their long-term goal is to make money.

They aim to make a surplus for their owners, paid out as dividends or retained profit.

What are non-profit organisations?

Non-profit organisations- any profit they do make is used to support their aim of maximising social welfare and helping indiviudals and groups. These organizations include charities and smaller organisations who are not large enough to be classified as charities.

They reivest any surplus into their social aims. They include charities (Oxfam, Cancer Research UK).

Why is a small market size a reason why firms stay small?

A small market size is a reason why firms stay small because niche or local demand limits how much can be sold

Why is limited access to finance a reason why some firms stay small?

Limited access to finance is a reason why some firms stay small because banks see small firms as risky, so loans cost more or are refused.

Why are owner objectives a reason why some firms stay small?

Owner objectives are a reason why some firms stay small because owners may satisfice (aim for enough profit) and value control or lifestyle over growth.

Why is government support a reason why some firms stay small?

Government support is a reason why some firms stay small because tax and rates relief can make staying small attractive. e.g small business rate relief→ a UK government scheme that lowers or eliminates the business rates tax for eligible commercial properties

Why is diversification a reason why some firms grow large?

Diversification is a reason why some firms grow large because selling more products or in more countries spreads risk

Why is managerial objectives a reason why some firms grow large?

Managerial objectives is a reason why some firms grow large because managers may pursue sales or revenue growth for status and pay

Why is survival a reason why some firms grow large?

Survival is a reason why some firms grow large because a bigger firm is harder to take over and better able to absorb shocks

What are the solutions for the principal-agent problem?

The solutions for the principal-agent problem=

• performance-related pay and bonuses

• share options

• non-executive directors

• shareholder votes at the AGM

• threat of takeover

Why is performance-related pay and bonuses a solution for the principal-agent problem and what is its evaluation point?

Performance-related pay bonuses are a solution for the principal-agent problem as it links managers’ rewards to profit. However, it may encourage short-term targets over long-term investment.

Why are share options a solution for the principal-agent problem and what is its evaluation point?

Share options are a solution for the principla-agent problem as managers become owners too, aligning objectives. However, this can tempt managers to boost the share price in the short run.

Why are non-executive directors a solution for the principal agent problem and what is its evaluation point?

Non- executive directors are a solution for the principal-agent problem as its an independent oversigh on the board. However, it only works if they are truly independent and well informed.

Why are shareholder votes at the AGM a solution for the principal agent problem and what is its evaluation point?

Shareholder votes at the AGM a sollution for the principal agent problem as shareholders can reject pay deals and remove directors. However, small shareholders rarely vote; institutions may be passive.

Why is a threat of takeover a solution for the principal agent problem and what is its evaluation point?

Threat of takeover is a solution for the principal agent problem as an underperforming firm has a low share price and may be bought. However, it is weak in very large firms that are costly to buy.