Sizes of Firms
Definition
Economies of scale: the fall in a firm's long-run average cost (LRAC) as it increases its scale of output.
Diseconomies of scale: the rise in long-run average cost that can occur when a firm grows beyond its minimum efficient scale, often through communication and coordination problems.
Minimum efficient scale (MES): the lowest output at which long-run average cost is minimised.
Key Idea
- Firms differ in size because growth brings both cost gains and cost penalties.
- The best size for a firm depends on its market, its finance and its owners' objectives.
Why Firms Grow Large
- Firms grow to exploit economies of scale, so long-run average cost falls as output rises and unit competitiveness improves.
- Lower average cost lets the firm cut price or widen its margin, so it wins sales and market share.
- Purchasing, technical, managerial, financial and risk-bearing economies each lower unit cost in a different way.
- A larger market share brings market power, so the firm gains more influence over price; a regional train operator with a franchise, for example, can raise fares with little loss of passengers.
- Higher output can raise total profit, funding dividends to owners and reinvestment in the firm.
- Diversifying into new products or markets spreads risk, so a downturn in one market does less damage.
- Managers may pursue growth for higher salary, status or security, reflecting their own aims rather than owners'.
Example
- A firm's fixed costs are £2,000,000, unchanged whatever the output; raising output by 900% (from 20,000 to 200,000 units) spreads them far more thinly.
- Average fixed cost falls from £100 to £10 per unit, a −90% change, so LRAC drops as scale rises: a technical economy of scale.
Why Firms Stay Small
- The size of the market may be too small to support a large firm.
- Small firms serve niche markets that large firms find unprofitable to enter, such as a bespoke tailor or artisan baker.
- They compete on flexibility and personal service rather than scale.
- Owners may prefer to keep control and avoid the debt and risk of rapid expansion.
- Limited access to finance restricts how far many firms can grow.
- Beyond the minimum efficient scale, diseconomies of scale raise LRAC, removing any gain from growing further.
Example
- A local bakery keeps loyal customers through personal service a national chain cannot match.
- A specialist watch-repair workshop serves a market too small to attract a large firm.
Determinants of Size
- The extent of economies of scale sets the minimum efficient scale in the industry.
- The size of the market limits how much output a firm can profitably sell; a small MES relative to demand lets many small firms survive.
- Access to finance and the firm's legal form shape how quickly it can expand.
- The objectives of owners and any regulation, such as a blocked merger, influence the chosen size.
Key Idea
- Large and small firms coexist because the best size depends on the minimum efficient scale relative to the size of the market.
- There is a trade-off: large firms gain productive efficiency from economies of scale but risk X-inefficiency and weaker innovation, while small firms are often more flexible and dynamic.
Should firms always aim to grow larger?
- Growing larger often helps a firm, because economies of scale lower long-run average cost, greater market power gives more influence over price, and higher output can raise total profit to fund reinvestment.
- But bigger is not always better: beyond the minimum efficient scale diseconomies of scale raise average cost, weak competition can breed X-inefficiency, and large firms may innovate less than nimble small rivals.
- The right size depends on the market: where the minimum efficient scale is small relative to demand, or where consumers value niche, flexible and personal service, small firms survive, and owners may also prefer to keep control rather than take on the debt and risk of expansion.
- On balance, a firm should grow only until the cost gains from scale are exhausted, so whether bigger is better depends on the size of economies of scale relative to the market and on the owners' objectives, which is why large and small firms coexist.
Exam technique
- State a reason for a firm's size, then explain the cost or revenue mechanism behind it.
- Link cost-based motives for growth back to economies of scale and the long-run average cost curve.
Common Mistake
- Do not assume larger is always better, as diseconomies of scale can raise average cost.
- Do not treat small firms as simply inefficient, since niche focus and low overheads can sustain them.
Self review
- Define economies of scale.
- Give three reasons a firm may grow larger.
- Give three reasons a firm may stay small.
- Explain how the size of the market limits a firm's size.
- Explain why growth is not always beneficial.
