Sizes and Types of Firms
Why Firms Grow or Stay Small
Economies of scale: the fall in long-run average cost as a firm increases its scale of output.
Diseconomies of scale: the rise in long-run average cost that can occur once a firm grows too large to coordinate efficiently.
Niche market: a small, specialised segment of a wider market that serves customers with particular needs.
- Firms grow to spread fixed costs over more units, capturing economies of scale that cut average cost and let them undercut rivals on price.
- Greater scale also brings market power, so the firm can hold price above marginal cost and earn larger supernormal profit.
- Widening the product range diversifies revenue, spreading risk so a downturn in one market does not threaten survival.
- Many firms stay small because they serve a niche where total demand is too limited to justify extra capacity.
- Small firms often cannot fund expansion, since they hold little retained profit and lenders treat them as higher risk.
- Owners may choose to stay small to keep personal control, protect a bespoke service, or avoid the diseconomies of scale that would raise average cost.
Divorce of Ownership from Control
Divorce of ownership from control: the separation in large firms between the shareholders who own the firm and the managers who run it.
Principal-agent problem: the conflict that arises when agents (managers) act in their own interest rather than that of the principals (owners) who employ them.
Asymmetric information: a situation where one party, here managers, holds more information than the other, here owners, can observe.
- Shareholders, the principals, want maximum profit and dividends, while managers, the agents, may prefer growth, status or an easier life.
- Because managers run daily operations, they hold information owners cannot observe, so owners struggle to check whether each decision serves them.
- This asymmetric information lets managers pursue their own aims at owners' expense, for example empire-building through unprofitable expansion.
- The divorce therefore explains why large firms may adopt objectives other than pure profit maximisation.
- At a listed plc such as Unilever, ownership is spread across thousands of dispersed shareholders who cannot monitor the board day to day, so the principal-agent problem is especially acute.
Public and Private Sector
Private sector: the part of the economy owned and run by individuals or shareholders rather than the state.
Public sector: the part of the economy owned and controlled by the government on behalf of citizens.
- Private sector firms answer to their owners, so profit and shareholder returns usually drive decisions, as at Tesco or Greggs.
- Public sector bodies answer to government, so social welfare and universal provision shape decisions, as in the NHS.
- Ownership therefore decides whose interests come first: private returns or public benefit.
Profit and Not-for-Profit Organisations
Profit-making organisation: an organisation that aims to earn a financial surplus for its owners or shareholders.
Not-for-profit organisation: an organisation that pursues a social or charitable purpose and reinvests any surplus rather than distributing it to owners.
- Most private firms are profit-making and use profit to reward owners and fund reinvestment.
- Not-for-profit bodies such as the British Red Cross, social enterprises and housing associations channel any surplus back into their purpose.
- The distinction lies in what happens to any surplus, not in whether the organisation can earn one.
Is growth always in the owners' best interests?
- It can be, because scale delivers economies of scale and market power that lift profit and the dividends shareholders receive.
- But manager-led growth can reflect the principal-agent problem, where empire-building raises managers' status while diseconomies of scale erode profit.
- Rapid growth can also overstretch finance and management, so a smaller, focused firm may earn a higher return on capital.
- On balance it depends on whether growth is pursued to cut average cost and raise profit, or simply to serve managers' own objectives.
- Identify who owns an organisation before stating its likely objective.
- Link private ownership to profit and state or charitable ownership to social aims.
- Tie the principal-agent problem to asymmetric information, not just to conflicting aims.
- Do not assume every organisation aims to make a profit.
- Do not describe the principal-agent problem without mentioning asymmetric information.
- Do not treat not-for-profit as meaning the organisation cannot earn a surplus.
- Give three reasons a firm might choose to stay small.
- Who are the principal and the agent, and why do their aims diverge?
- How does asymmetric information create the principal-agent problem?
- How do the objectives of public and private sector organisations differ?
- What distinguishes a profit organisation from a not-for-profit one?
